CAPM - The Capital Asset Pricing Model

"Cap-M" looks at risk and rates of return and compares them to the overall stock market.
If you use CAPM you have to assume that most investors want to avoid risk, (risk
averse), and those who do take risks, expect to be rewarded. It also assumes that investors
are "price takers" who can't influence the price of assets or markets. With CAPM you
assume that there are no transactional costs or taxation and assets and securities are
divisible into small little packets. Had enough with the assumptions yet? One more.
CAPM assumes that investors are not limited in their borrowing and lending under the
risk free rate of interest. By now you likely have a healthy feeling of skepticism. We'll
deal with that below, but first, let's work the CAPM formula.

Beta - Now, you gotta know about Beta. Beta is the overall risk in investing in a large
market, like the New York Stock Exchange. Beta, by definition equals 1.0000. 1 exactly.
Each company also has a beta. You can find a company's beta at the Yahoo!! Stock quote
page. A company's beta is that company's risk compared to the risk of the overall market.
If the company has a beta of 3.0, then it is said to be 3 times more risky than the overall
market.

Ks = Krf + B ( Km - Krf)

• Ks = The Required Rate of Return, (or just the rate of return).

• Krf = The Risk Free Rate (the rate of return on a "risk free investment", like U.S.
Government Treasury Bonds - Read our Disclaimer)
• B = Beta (see above)
• Km = The expected return on the overall stock market. (You have to guess what
rate of return you think the overall stock market will produce.)

Investopedia explains Capital Asset Pricing Model - CAPM

The CAPM says that the expected return of a security or a portfolio equals the rate on a
risk-free security plus a risk premium. If this expected return does not meet or beat the
required return, then the investment should not be undertaken. The security market line
plots the results of the CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected
return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk
measure) of the stock is 2 and the expected market return over the period is 10%, the
stock is expected to return 17% (3%+2(10%-3%)).
Assumptions of the Capital Asset Pricing Model

Note! The Capital Asset Pricing Model is a ceteris paribus model. It is only valid within a
special set of assumptions. These are:

• Investors are risk averse individuals who maximize the expected utility of
their end of period wealth. Implication: The model is a one period model.
• Investors have homogenous expectations (beliefs) about asset returns.
Implication: all investors perceive identical opportunity sets. This means
everyone has the same information at the same time.
• Asset returns are distributed by the normal distribution.
• There exists a risk free asset and investors may borrow or lend unlimited
amounts of this asset at a constant rate: the risk free rate.
• There is a definite number of assets and their quantities are fixated within
the one period world.
• All assets are perfectly divisible and priced in a perfectly competitive
marked. Implication: e.g. human capital is non-existing (it is not divisible and it
can't be owned as an asset).
• Asset markets are frictionless and information is costless and
simultaneously available to all investors. Implication: borrowing rate equals the
lending rate.
• There are no market imperfections such as taxes, regulations, or restrictions on short
selling.

Who introduced the CAPM - Capital Asset Pricing Model?

Harry Markowitz worked on diversification and modern portfolio theory. Jack Treynor,
John Lintner, Jan Mossin and William Sharpe all contributed to the theory of CAPM.
William Sharpe, Harry Markowitz and Merton Miller jointly got a Nobel Prize in
Economics for contributing to financial economics. See, if you study hard and think up
new stuff maybe you can get a Nobel Prize too.

Ah, but CAPM has some flaws.

• If you go to a casino, you basically pay for risk. It's possible that the folks on Wall
Street sometimes have the same mindset as well. Now remember that CAPM
assumes that given "X%" expected return investors will prefer lower risk (in other
words lower variance) to higher risk. And the opposite would be true as well -
given a certain level of risk investors would prefer higher returns to lower ones.
OK, but maybe the Wall Street people get a kick out of "gambling" their
 investment. Not saying it's been proven to be the case, just saying it could be.
CAPM doesn't allow for investors who will accept lower returns for higher risk.
• CAPM assumes that asset returns are jointly normally distributed random
variables. But often returns are not normally distributed. So large swings, swings
as big as 3 to 6 standard deviations from the mean, occur in the market more
frequently than you would expect in a normal distribution.
• CAPM assumes that the variance of returns adequately measures risk. This might
be true if returns were distributed normally. However other risk measurements are
probably better for showing investors' preferences. Coherent risk measures comes
to mind.
• With CAPM you assume that all investors have equal access to information and
they all agree about the risk and expected return of the assets. This idea, by the
way is called "homogeneous expectations assumption". Be ready for your
professor to ask, "What's the Homogeneous Expectations Assumption and do you
believe it's valid". Good luck with that one.
• CAPM can't quite explain the variation in stock returns. Back in 1969, Myron
Scholes, Michael Jensen and Fisher Black presented a paper suggesting that low
beta stocks may offer higher returns than the model would predict.
• CAPM kind of skips over taxes and transaction costs. Some of the more complex
versions of CAPM try to take this into consideration.
• CAPM assumes that all assets can be divided infinitely and that those small assets
can be held and transacted.
• Roll's Critique: Back in 1977, Richard Roll offered the idea that using stock
indexes as a proxy for the true market portfolio can lead to CAPM being invalid.
The true market portfolio should include stuff like real estate, human capital,
works of art and so on, basically anything that anyone holds as an investment.
However, the markets for those assets are often non-transparent and unobservable.
So often financial people will use a stock index instead. Does it kind of seem like
they are fudging a little bit. You might argue they are.
• CAPM assumes that individual investors have no preference for markets or assets
other than their risk-return profile. But is that really the case? Say a guy loves
drinking Coke. Only Coke. He's collects old Coke bottles and stuff. OK, now, is
that guy going to buy stock in Pepsi based only on its risk-return profile, or is he
going to buy stock in Coke so he can brag to everyone about how many shares he
has?