Guidelines

What Is Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a financial model used to calculate the theoretically appropriate required rate of return of an asset or investment, considering both its risk and the time value of money. This foundational model, rooted in portfolio theory, helps investors determine what return they should expect for taking on a specific level of risk. The CAPM suggests that the expected return on a security is equal to the risk-free rate plus a risk premium, which is based on the security's sensitivity to market risk. The Capital Asset Pricing Model helps establish an appropriate discount rate for future cash flows.

History and Origin

The Capital Asset Pricing Model was developed independently by several economists in the early 1960s, notably William F. Sharpe (1964), Jack Treynor (1961, 1962), John Lintner (1965a, b), and Jan Mossin (1966)¹⁰, ¹¹, ¹². Their work built upon Harry Markowitz's pioneering "Portfolio Selection" (1952), which introduced the concept of portfolio diversification and laid the groundwork for Modern Portfolio Theory⁸, ⁹.

Prior to the CAPM, understanding the explicit relationship between risk and expected return was less formalized in financial markets⁷. The model emerged during a period when the theoretical foundations of decision-making under uncertainty were still developing⁶. William Sharpe, who shared the Nobel Memorial Prize in Economic Sciences in 1990 for his contributions, notably simplified Markowitz's work by connecting a portfolio to a single risk factor⁵. The CAPM provided a coherent framework for assessing how the risk of an investment should influence its expected return, revolutionizing the field of finance by offering a practical means to evaluate asset pricing³, ⁴.

Key Takeaways

• The Capital Asset Pricing Model calculates the expected return for an asset, given its risk relative to the overall market.
• It differentiates between systematic risk (market risk, non-diversifiable) and unsystematic risk (specific risk, diversifiable).
• The model uses beta as a measure of an asset's systematic risk.
• CAPM is widely applied in determining the cost of capital for companies and evaluating investment performance.
• Despite its theoretical importance and practical use, the Capital Asset Pricing Model faces criticisms regarding its simplifying assumptions and empirical limitations.

Formula and Calculation

The formula for the Capital Asset Pricing Model is:

$E(R_i) = R_f + \beta_i * (E(R_m) - R_f)$

Where:

• (E(R_i)) = Expected return of the investment
• (R_f) = Risk-free rate
• (\beta_i) = Beta of the investment (a measure of its systematic risk)
• (E(R_m)) = Expected return of the market
• ((E(R_m) - R_f)) = Market risk premium

This formula suggests that the expected return on an asset is the sum of the risk-free rate and a risk premium, where the risk premium is determined by the asset's beta multiplied by the market risk premium.

Interpreting the Capital Asset Pricing Model

The Capital Asset Pricing Model provides a benchmark for what an investor should expect to earn for taking on a certain level of systematic risk. If an asset's projected return, based on its potential future cash flows, is higher than the return calculated by the CAPM, it might be considered undervalued. Conversely, if its projected return is lower, it might be overvalued. The model's output can be visualized on the Security Market Line (SML), which plots beta against expected return. Assets that fall above the SML are considered to offer a higher return for a given level of systematic risk, while those below offer a lower return. Understanding the relationship between risk and reward is crucial for establishing an equilibrium price for securities.

Hypothetical Example

Consider an investor evaluating a stock, Stock XYZ. The current risk-free rate (e.g., U.S. Treasury bond yield) is 3%. The expected return of the overall market, represented by a broad market index, is 10%. Stock XYZ has a beta of 1.2.

Using the CAPM formula:

$E(R_{XYZ}) = R_f + \beta_{XYZ} * (E(R_m) - R_f)$
$E(R_{XYZ}) = 0.03 + 1.2 * (0.10 - 0.03)$
$E(R_{XYZ}) = 0.03 + 1.2 * 0.07$
$E(R_{XYZ}) = 0.03 + 0.084$
$E(R_{XYZ}) = 0.114 \text{ or } 11.4\%$

According to the Capital Asset Pricing Model, the investor should expect an 11.4% return from Stock XYZ, given its risk profile. If the investor's analysis suggests Stock XYZ is likely to generate, for example, a 13% return, it might be an attractive investment. This example highlights how the model provides a quantifiable expected return benchmark against which actual or forecasted returns can be compared for individual securities within a portfolio diversification strategy.

Practical Applications

The Capital Asset Pricing Model is widely used across various areas of finance:

• Investment Analysis: Analysts use the CAPM to estimate the required rate of return for equity investments, aiding in fundamental valuation and decision-making.
• Capital Budgeting: Corporations employ the CAPM to determine the appropriate discount rate for evaluating potential projects, ensuring that the expected returns compensate for the project's systematic risk.
• Performance Measurement: Portfolio managers use the model's output as a benchmark to assess whether their managed portfolios are generating returns commensurate with their risk levels.
• Regulatory Settings: While not directly mandated for all disclosures, the principles of risk and return, including the distinction between diversifiable and non-diversifiable risk, are central to regulatory frameworks that emphasize transparent risk communication to investors [sec.gov]. Regulators, like the SEC, provide guidance on understanding various types of investment risk.
• Asset Allocation: Investors consider the CAPM's implications for how different assets contribute to overall portfolio risk and return, guiding their asset allocation decisions to reach the efficient frontier.

Limitations and Criticisms

Despite its widespread use, the Capital Asset Pricing Model is subject to several significant limitations and criticisms:

• Simplifying Assumptions: The model relies on a number of strong assumptions, such as investors holding diversified portfolios, having homogeneous expectations, and being able to borrow and lend at the risk-free rate, which do not perfectly reflect real-world market conditions.
• Single-Factor Model: The CAPM is a single-factor model, meaning it attributes all systematic risk solely to market movements. However, empirical studies, such as those by Eugene Fama and Kenneth French, suggest that other factors, like company size and value, also influence asset returns².
• Beta Instability: The beta of a security is not always stable over time, and its historical calculation may not accurately predict future systematic risk.
• Market Portfolio Definition: The model theoretically requires the "market portfolio" to include all risky assets (e.g., real estate, human capital), which is impractical to observe or use in practice¹.
• Empirical Failures: Numerous empirical tests have shown that the CAPM does not always accurately predict returns. For instance, low-volatility stocks have sometimes yielded higher returns than the model would suggest, a phenomenon known as the low-volatility anomaly [2, reuters.com]. This suggests that market efficiency may not always hold true, leading to discrepancies between predicted and actual returns in the market [https://www.reuters.com/markets/europe/investors-chase-low-volatility-stocks-that-defy-market-logic-2021-08-04/]. Some research indicates that the assumption that variance fully captures risk may not always hold, especially for investors with very low risk tolerances.

Capital Asset Pricing Model vs. Arbitrage Pricing Theory

While both the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are asset pricing models that aim to explain the relationship between risk and expected return, they differ fundamentally in their approach. The CAPM is a single-factor model, positing that only systematic market risk, measured by beta, drives expected returns. It explicitly specifies this risk factor (the market risk premium). In contrast, the Arbitrage Pricing Theory is a multi-factor model that suggests asset returns can be explained by multiple systematic risk factors, though it does not specify what these factors are. APT allows for various macroeconomic or industry-specific factors to influence returns, whereas CAPM is more restrictive in its view of risk drivers. Consequently, APT is generally seen as more flexible and less reliant on restrictive assumptions about investor behavior and market efficiency than the CAPM.

FAQs

What is the primary purpose of the Capital Asset Pricing Model?

The primary purpose of the Capital Asset Pricing Model is to estimate the required rate of return for an investment, considering its systematic risk relative to the overall market. It helps investors determine if an asset's expected return is fair given its risk.

How is beta used in the CAPM?

Beta in the CAPM measures an investment's sensitivity to market movements, representing its systematic risk. A beta of 1 means the asset's price moves with the market, a beta greater than 1 means it's more volatile than the market, and a beta less than 1 means it's less volatile.

Does the CAPM account for all types of risk?

No, the Capital Asset Pricing Model primarily accounts for systematic risk, which is the non-diversifiable risk inherent to the entire market. It assumes that unsystematic risk, or specific company risk, can be eliminated through portfolio diversification.

Is the Capital Asset Pricing Model still relevant today?

Despite its criticisms and the development of more complex models, the Capital Asset Pricing Model remains a widely taught and used concept in finance. Its simplicity and intuitive framework for understanding the relationship between risk and return make it a valuable tool for financial education, fundamental valuation, and estimating the cost of capital.