Capital Asset Pricing Model - CAPM

What Does Capital Asset Pricing Model - CAPM Mean?

A model that describes the relationship between risk and expected return and that is used in the pricing of
risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of
money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and
compensates the investors for placing money in any investment over a period of time. The other half of
the formula represents risk and calculates the amount of compensation the investor needs for taking
on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the
asset to the market over a period of time and to the market premium (Rm-rf).

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%))

CAPM's starting point is the risk-free rate - typically a 10-year government bond yield. To this is added a
premium that equity investors demand to compensate them for the extra risk they accept. This equity
market premium consists of the expected return from the market as a whole less the risk-free rate of
return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta".

Beta
According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's
relative volatility - that is, it shows how much the price of a particular stock jumps up and down compared
with how much the stock market as a whole jumps up and down. If a share price moves exactly in line
with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose
by 10%, and fall by 15% if the market fell by 10%. (For further reading, see Beta: Gauging Price
Fluctuations and Beta: Know The Risk.)

Beta is found by statistical analysis of individual, daily share price returns, in comparison with the market's
daily returns over precisely the same period. In their classic 1972 study titled "The Capital Asset Pricing
Model: Some Empirical Tests", financial economistsFischer Black, Michael C. Jensen and Myron
Scholes confirmed a linear relationship between the financial returns of stock portfolios and their betas.
They studied the price movements of the stocks on the New York Stock Exchange between 1931 and
1965. 
Beta, compared with the equity risk premium, shows the amount of compensation equity investors need
for taking on additional risk. If the stock's beta is 2.0, the risk-free rate is 3% and the market rate of return
is 7%, the market's excess return is 4% (7% - 3%). Accordingly, the stock's excess return is 8% (2 X 4%,
multiplying market return by the beta), and the stock's total required return is 11% (8% + 3%, the stock's
excess return plus the risk-free rate).

What this shows is that a riskier investment should earn a premium over the risk-free rate - the amount
over the risk-free rate is calculated by the equity market premium multiplied by its beta. In other words, it's
possible, by knowing the individual parts of the CAPM, to gauge whether or not the current price of a
stock is consistent with its likely return - that is, whether or not the investment is a bargain or too
expensive. 

What CAPM Means for You

This model presents a very simple theory that delivers a simple result. The theory says that the only
reason an investor should earn more, on average, by investing in one stock rather than another is that
one stock is riskier. Not surprisingly, the model has come to dominate modern financial theory. But does it
really work?

It's not entirely clear. The big sticking point is beta. When professors Eugene Fama and Kenneth French
looked at share returns on the New York Stock Exchange, the American Stock Exchange and Nasdaq
between 1963 and 1990, they found that differences in betas over that lengthy period did not explain the
performance of different stocks. The linear relationship between beta and individual stock returns also
breaks down over shorter periods of time. These findings seem to suggest that CAPM may be wrong.
While some studies raise doubts about CAPM's validity, the model is still widely used in the investment
community. Although it is difficult to predict from beta how individual stocks might react to particular
movements, investors can probably safely deduce that a portfolio of high-beta stocks will move more than
the market in either direction, and a portfolio of low-beta stocks will move less than the market.

This is important for investors - especially fund managers - because they may be unwilling to or prevented
from holding cash if they feel that the market is likely to fall. If so, they can hold low-beta stocks instead.
Investors can tailor a portfolio to their specific risk-returnrequirements, aiming to hold securities with betas
in excess of 1 while the market is rising, and securities with betas of less than 1 when the market is
falling.

Not surprisingly, CAPM contributed to the rise in use of indexing - assembling a portfolio of shares to
mimic a particular market - by risk averse investors. This is largely due to CAPM's message that it is only
possible to earn higher returns than those of the market as a whole by taking on higher risk (beta). (To
learn more, see The Lowdown On Index Funds.)

Conclusion
The capital asset pricing model is by no means a perfect theory. But the spirit of CAPM is correct. It
provides a usable measure of risk that helps investors determine what return they deserve for putting their
money at risk.

How Risk Free Is The Risk-Free Rate Of Return?

The risk-free rate of return is one of the most basic components of modern finance and many of its most
famous theories - the capital asset pricing model (CAPM), modern portfolio theory (MPT) and the Black-
Scholes model - use the risk-free rate as the primary component from which other valuations are derived.
The risk-free asset only applies in theory, but its actual safety rarely comes into question until events fall
far beyond the normal daily volatile markets. Although it's easy to take shots at theories that have a risk-
free asset as their base, there are limited options to use as a proxy. 

The model assumes that investors are risk averse and will expect a certain rate of return for excess risk
extending from the intercept, which is the risk-free rate of return. 
Capital asset pricing model
From Wikipedia, the free encyclopedia

An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial Average over the last 3 years
for monthly data.

In finance, the capital asset pricing model (CAPM) is used to determine a theoretically appropriate
required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that
asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also
known assystematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as
well as the expected return of the market and the expected return of a theoretical risk-free asset.

The model was introduced by Jack Treynor (1961, 1962),[1] William Sharpe (1964), John Lintner (1965a,b)

and Jan Mossin (1966) independently, building on the earlier work of Harry
Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly received
the Nobel Memorial Prize in Economics for this contribution to the field of financial economics.

Ah, but CAPM has some flaws. (don't we all)

 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?

Asset pricing
Once the expected/required rate of return, E(Ri), is calculated using CAPM, we can compare this
required rate of return to the asset's estimated rate of return over a specific investment horizon to
determine whether it would be an appropriate investment. To make this comparison, you need an
independent estimate of the return outlook for the security based on either fundamental or technical
analysis techniques, including P/E, M/B etc.
In theory, therefore, an asset is correctly priced when its estimated price is the same as the required rates
of return calculated using the CAPM. If the estimate price is higher than the CAPM valuation, then the
asset is undervalued (and overvalued when the estimated price is below the CAPM valuation).

Asset-specific required return

The CAPM returns the asset-appropriate required return or discount rate—i.e. the rate at which future
cash flows produced by the asset should be discounted given that asset's relative riskiness. Betas
exceeding one signify more than average "riskiness"; betas below one indicate lower than average. Thus,
a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will
have lower betas and be discounted at a lower rate. Given the accepted concave utility function, the
CAPM is consistent with intuition—investors (should) require a higher return for holding a more risky
asset.

Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a whole,
by definition, has a beta of one. Stock market indices are frequently used as local proxies for the market
—and in that case (by definition) have a beta of one. An investor in a large, diversified portfolio (such as
a mutual fund), therefore, expects performance in line with the market.

Assumptions of CAPM
All investors:

1. Aim to maximize economic utilities.

2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers, i.e., they cannot influence prices.
5. Can lend and borrow unlimited amounts under the risk free rate of interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible into small parcels.
8. Assume all information is available at the same time to all investors.