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The Capital Asset Pricing Model (CAPM)
is an economic model for valuing
stocks, securities, derivatives and/or assets by relating risk and
expected return. CAPM is based on the idea that investors demand
additional expected return (called the risk premium) if they are asked to accept
additional risk.
The CAPM model says that this expected return that these investors would
demand is equal to the rate on a risk-free security plus a
risk premium. If the expected return does not meet/beat the required
return, the investors will refuse to invest and the investment should not be undertaken.
The CAPM formula is:
Expected Security Return = Riskless
Return + Beta x (Expected Market Risk Premium)
or:
r = Rf + Beta x (RM - Rf)
{ Another
version of the formula is: r-Rf = Beta x (RM - Rf)
}
where:
- r is the
expected return rate on a security;
- Rf is the rate of a
"risk-free" investment, i.e. cash;
- RM is the return rate of the
appropriate asset class.
Beta is the overall risk in investing
in a large market, like the New York Stock Exchange. Beta, by definition
equals 1,00000 exactly.
Each company also has a Beta. A company's
Beta is that
company's risk compared to the Beta (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. Beta measures the volatility of the security, relative to
the asset class.
A consequence of CAPM-thinking
is that it implies that investing in individual stocks is pointless,
because one can duplicate the reward and risk characteristics of any
security just by using the right mix of cash with the appropriate asset
class. This is why die-hard followers of
CAPM avoid stocks, and instead build portfolios
merely out of low-cost index funds.
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 is,
everyone have 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 fixed
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: the borrowing rate
equals the lending rate.
· There are no market imperfections such as taxes, regulations, or
restrictions on short selling.
Although the assumptions mentioned above normally are not all valid or
met, CAPM remains one of the most used investments models to determine
risk and return.
William Sharpe was the 1990
Nobel price winner for Economics "For his contributions to the theory of
price formation for financial assets, the so-called Capital Asset Pricing
Model (CAPM)."
Book: William F. Sharpe - Portfolio Theory and Capital Markets - 
Book: Harry M. Markowitz - Mean-Variance Analysis in Portfolio Choice and
Capital Markets -
Book: Mary Jackson - Advanced modelling in finance using Excel and VBA -
Compare:
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