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 Capital Asset Pricing Model?
- 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 + 𝛽(Rm – Rf)
(Where R(e) = expected return on an investment, Rf = risk-free rate, Rm = expected return of the market, 𝛽 = beta of a stock)
- Beta 𝛽
- 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 Capital Asset Pricing Model 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.