The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk, or the general perils of investing, and expected to return for assets, particularly stocks. It is a finance model that establishes a linear relationship between the required return on investment and risk.
What is CAPM?
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security. Below is an illustration of the CAPM concept.
Key Features:
- The capital asset pricing model – or CAPM – is a financial model that calculates the expected rate of return for an asset or investment.
- CAPM does this by using the expected return on both the market and a risk-free asset, and the asset’s correlation or sensitivity to the market (beta).
- There are some limitations to the CAPM, such as making unrealistic assumptions and relying on a linear interpretation of risk vs. return.
- Despite its issues, the CAPM formula is still widely used because it is simple and allows for easy comparisons of investment alternatives.
- For instance, it is used in conjunction with modern portfolio theory (MPT) to understand portfolio risk and expected return.
CAPM Formula and Calculation
CAPM is calculated according to the following formula:
Where:
Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market
Note: “Risk Premium” = (Rm – Rrf)
The CAPM formula is used for calculating the expected returns of an asset. It is based on the idea of systematic risk (otherwise known as non-diversifiable risk) that investors need to be compensated for in the form of a risk premium. A risk premium is a rate of return greater than the risk-free rate. When investing, investors desire a higher risk premium when taking on more risky investments.
Why CAPM is Important?
The CAPM formula is widely used in the finance industry. It is vital in calculating the weighted average cost of capital (WACC), as CAPM computes the cost of equity.
WACC is used extensively in financial modeling. It can be used to find the net present value (NPV) of the future cash flows of an investment and to further calculate its enterprise value and finally its equity value.
Advantages of CAPM
- CAPM considers only the systematic or market risk or not the security’s only inherent or systemic risk. This factor eliminates the vagueness associated with an individual security risk, and only the general market risk, which has a degree of certainty, becomes the primary factor. The model assumes that the investor holds a diversified portfolio, and hence the unsystematic risk is eliminated between the stock holdings.
- It is widely used in the finance industry to calculate the cost of equity and ultimately the weighted average cost of capital, which is used extensively to check the cost of financing from various sources. It is seen as a much better model to calculate the cost of equity than the other present models like the Dividend growth model (DGM)
- It is a universal and easy-to-use model. Given the extensive presence of this model, this can easily be utilized for comparisons between stocks of various countries.
Disadvantages of CAPM
The capital asset pricing model is hinged on various assumptions. One of the assumptions is that a riskier asset will yield a higher return.
Next, the historical data is used to calculate Beta. The model also assumes that past performance is a good measure of the future results of a stock’s functioning. However, that is far from the truth.
The model also assumes that the risk-free return will remain constant throughout the stock investment.
If the return on the government treasury securities rises or falls, it will change the risk-free return and potentially the calculation of the model. It is not taken into account while calculating the CAPM.
The model assumes that the investors have access to the same information and have the same decision-making process concerning the risks and returns associated with the securities.
It assumes that the investors will prefer low-risk securities to high-risk securities for a given return. Investors will prefer higher returns to lower returns for a given risk. Although this is a general guideline, some of the more extravagant investors might not be in agreement with this theory.
Limitations of the Capital Asset Pricing Model
Apart from the assumptions directly related to the factors around the stock and the capital asset pricing model calculation formula, there is a list of general assumptions that the model takes, which are worth looking into.
Only the returns and risks involved in the securities are the decision-making factors for an investor.
There is no accountability for the long-term growth or qualitative factors around a stock that could influence the investor to take an alternative step.
There is perfect competition in the market, and no single investor can influence a stock’s prices or returns.
There is no limit on the short-selling short-selling of a stock; neither is their control on the divisibility of the purchase and selling units.
There are nil taxes regarding the returns earned or any borrowing costs concerning the amount utilized to earn interest on the investment.
Finally, the model assumes that the investor is risk-averse, and he is supposed to act as a rational being and maximize his utility.
Conclusion
CAPM is widely regarded as one of the foremost models for calculating the risk and returns associated with investing in stocks. Although it utilizes a few assumptions, the rationale behind the model and the ease of use makes it one of the accepted and logical ways to help investors in their decision-making.
