Capital Asset Pricing Model

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 with CAPM: Real Options  |  RAROC  |  Plausibility Theory  |  Operations Research  |  Relative Value of Growth

More financial methods

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