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What is the Capital Asset Pricing Model (CAPM)?

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What is the Capital Asset Pricing Model (CAPM)? was originally published here.

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Definition of Capital Asset Pricing Model

  • CAPM is a model used by investors to estimate the expected return of an asset.
  • It helps an investor understand what to expect to earn in relation to the risk-free rate and the market return.
  • CAPM assumes that the minimum a rational investor would earn is the risk-free rate by buying the risk-free asset.
  • If an investor moves money from the risk-free asset into the stock market, they should expect to earn a return in excess of the risk-free rate, what is called an equity risk premium.
  • When an investor buys a particular security, they consider the risk of that security relative to the riskiness of the overall market and adjust the equity risk premium up or down by using Beta.
  • Beta is a multiple used to adjust up (Beta > 1) the equity risk premium if a stock is expected to be riskier than the market, and down (Beta < 1) if the stock is lower risk than the market.

What Impacts the Capital Asset Pricing Model?

  • Investments are exposed to two types of risk: systematic and unsystematic.
  • Systematic risks are uncontrollable market risks due to unavoidable external factors.
    • Systematic risks include interest rates, economic fluctuations, political unrest, pandemics, etc.
  • Unsystematic risks are risks specific to a particular stock, which is why they are also called, company-specific risk. These risks can be reduced through the diversification of a portfolio.

How Do You Calculate the CAPM?

  • The formula for CAPM is the risk-free rate plus beta multiplied by the market risk premium, which is the difference between the expected return on the market and the risk-free rate

E(r) = Rf + ?(Rm – Rf)

(Where R(e) = expected return on an investment, Rf = risk-free rate, Rm = expected return of the market, ? = beta of a stock)

  • Beta ?
    • The beta measures the sensitivity of a stock in relation to changes in the market.
    • The beta indicates the required amount of compensation for any increase in investment risk.
    • A portfolio of stocks with high beta is more sensitive to changes in the market, indicating a higher expected return.
    • A portfolio of stocks with low beta is less sensitive to changes in the market, indicating a lower expected return.

Why is the Capital Asset Pricing Model Important?

  • Investors are able to use CAPM to evaluate their investment’s performance on individual stocks and portfolios in comparison to market performance.
  • The CAPM formula is used to calculate the cost of equity, which is crucial in the computation of the weighted average cost of capital (WACC).

The CAPM in Practice

  • CAPM implies assumptions such as markets without transaction costs, taxes, etc.
  • Investors and fund managers can diversify their portfolios through combinations of stocks based on the expected changes in the market.
  • Unfortunately, applying the CAPM is nearly impossible for a few reasons
    • First, you cannot just plug in past returns and betas, all inputs must be unknown estimates of the future.
    • Second, Beta is impossible to estimate, in fact, our research shows that the Beta to use is NOT the easily calculated historic beta.
    • Third, the model uses only one measure of risk, Beta, yet we know there are multiple factors that can determine the risk of a stock.
    • Fourth, the calculation of beta considers variance as the sole measure of risk, however, to a typical investor, the variance is not necessarily a risk.

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