Capital Asset Pricing Model Definition & Examples

Published Apr 6, 2024

Definition of Capital Asset Pricing Model (CAPM)

The CAPM is a financial model used to determine the expected return on an investment, given its risk relative to the market. It shows the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used in finance for pricing risky securities, generating expected returns for assets given their risk, and calculating costs of capital.

Formula and Components

The CAPM formula is represented as:

\[ E(R_i) = R_f + \beta_i (E(R_m) – R_f) \]

Where:

\(E(R_i)\): Expected return of the investment
\(R_f\): Risk-free rate of return
\(\beta_i\): Beta of the investment, representing its risk in comparison to the market
\(E(R_m) – R_f\): Market risk premium, the expected excess return of the market over the risk-free rate

Example

Let’s consider an example where the risk-free rate is 3%, the expected market return is 8%, and a stock with a beta of 1.5 is under evaluation.

Expected Return of the Stock:
\[ E(R_i) = 3\% + 1.5(8\% – 3\%) \]
\[ E(R_i) = 3\% + 1.5(5\%) \]
\[ E(R_i) = 3\% + 7.5\% \]
\[ E(R_i) = 10.5\% \]

This calculation suggests that, given its risk, the expected return on the stock is 10.5% per year.

Why CAPM Matters

CAPM offers several critical insights in finance, including:

Risk and Return Trade-off: It quantifies the trade-off between the risk of an investment and its expected return, showing that higher risk demands higher expected returns.
Portfolio Management: Investors and portfolio managers use CAPM to assess the performance of securities and optimize their investment portfolios for a balanced risk-return profile.
Capital Budgeting: Businesses employ CAPM to estimate the cost of capital, including the cost of equity, which is crucial for evaluating investment projects and making long-term financial decisions.

Frequently Asked Questions (FAQ)

How does CAPM differentiate between systematic and unsystematic risk?

CAPM focuses on systematic risk, represented by the beta (\(\beta\)) coefficient. Systematic risk is the inherent risk associated with the overall market that cannot be diversified away. In contrast, unsystematic risk is company or industry-specific risk that can be mitigated through diversification. CAPM assumes investors hold diversified portfolios to eliminate unsystematic risk, focusing only on the compensation required for bearing systematic risk.

Is CAPM applicable in all types of markets?

CAPM is widely applicable but has limitations, particularly in markets that are highly volatile or less efficient, where information asymmetry and diverse investor behaviors can skew the relationship between risk and return. Additionally, the assumptions of CAPM, such as risk-free assets and borrowing rates, may not hold in all scenarios, affecting its applicability.

How reliable is the beta (\(\beta\)) in the CAPM formula?

The reliability of beta as a measure of risk depends on several factors, including the time frame of historical data used and the changes in market conditions. Beta can provide a reasonable estimate of a security’s market risk but may not fully account for new market dynamics or structural changes in a company’s operations. It’s also important to remember that past performance is not always indicative of future results.

CAPM remains a foundational tool in the fields of finance and investment, providing a structured way to think about risk, return, and the valuation of assets. Its simplicity and broad applicability make it an essential model despite criticisms and alternatives suggesting more complex relationships between risk and expected returns.