Scholarly articles

What Is the Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a foundational model within Asset Pricing Theory that describes the relationship between the expected return on an investment and its systematic risk. The CAPM suggests that the expected return for a given security or portfolio is equal to the risk-free rate plus a risk premium that is based on that security's or portfolio's beta⁵³. Essentially, the Capital Asset Pricing Model provides a framework for evaluating whether an asset's expected return compensates investors adequately for the risk they undertake. It is widely used in corporate finance and investment decision-making to calculate the cost of equity and determine the appropriate discount rate for future cash flows⁵²,⁵¹.

History and Origin

The Capital Asset Pricing Model was independently developed in the early 1960s by several economists, including William F. Sharpe (1964), Jack Treynor (1962), John Lintner (1965), and Jan Mossin (1966). Their work built upon the earlier breakthroughs in modern portfolio theory by Harry Markowitz, who focused on how investors could construct efficient portfolios⁵⁰. William F. Sharpe was particularly recognized for his contributions, sharing the 1990 Nobel Memorial Prize in Economic Sciences "for their pioneering work in the theory of financial economics," specifically citing his development of the Capital Asset Pricing Model⁴³, ⁴⁴, ⁴⁵, ⁴⁶, ⁴⁷, ⁴⁸, ⁴⁹. This model revolutionized the understanding of how risk and expected return are related in financial markets, providing a coherent framework where little theoretical understanding existed previously⁴².

Key Takeaways

• The Capital Asset Pricing Model links an asset's expected return to its systematic risk.
• It posits that investors are compensated only for systematic risk, as firm-specific risk can be eliminated through diversification.
• The model's core components are the risk-free rate, the asset's beta coefficient, and the market risk premium.
• CAPM is a widely used tool for calculating the cost of equity and is a key input in determining the weighted average cost of capital (WACC).

Formula and Calculation

The Capital Asset Pricing Model is represented by the following formula:

Where:

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

The beta ((\beta)) in the formula quantifies an asset's sensitivity to market movements⁴¹. It is calculated as the covariance between the asset's expected return and the market's expected return, divided by the variance of the market's expected return⁴⁰.

Interpreting the Capital Asset Pricing Model

Interpreting the Capital Asset Pricing Model involves understanding how each component influences the expected return of an asset. The model suggests that the expected return of a security should compensate investors for two main factors: the time value of money, represented by the risk-free rate, and the unavoidable market risk, represented by the risk premium multiplied by beta³⁹.

A security with a beta of 1 is expected to move in line with the market. A beta greater than 1 indicates that the security is more volatile than the market, implying a higher expected return to compensate for the increased risk. Conversely, a beta less than 1 suggests lower volatility than the market and a correspondingly lower expected return³⁸. The relationship between an asset's systematic risk (beta) and its expected return is graphically depicted by the security market line (SML)³⁷. Assets plotting above the SML are considered undervalued, while those below are considered overvalued, according to the CAPM.

Hypothetical Example

Consider an investor evaluating a stock, Company X.
Let's assume the following hypothetical values:

• Risk-free rate ((R_f)) = 3%
• Expected market return ((E(R_m))) = 10%
• Beta of Company X ((\beta_X)) = 1.2

Using the CAPM formula:
(E(R_X) = R_f + \beta_X (E(R_m) - R_f))
(E(R_X) = 0.03 + 1.2 (0.10 - 0.03))
(E(R_X) = 0.03 + 1.2 (0.07))
(E(R_X) = 0.03 + 0.084)
(E(R_X) = 0.114) or 11.4%

In this scenario, the Capital Asset Pricing Model suggests that the expected return for Company X should be 11.4% to compensate the investor for its level of systematic risk. If Company X is projected to yield returns higher than 11.4%, it might be considered an attractive investment. This analysis helps investors make informed portfolio management decisions.

Practical Applications

The Capital Asset Pricing Model is a widely utilized tool in various financial contexts, despite its theoretical assumptions. It serves as a cornerstone for several real-world applications:

• Capital Budgeting: Companies use the CAPM to estimate the cost of equity for new projects or investments, which is crucial for determining the appropriate discount rate in net present value (NPV) and internal rate of return (IRR) analyses³⁶,³⁵. This helps firms assess if a project's expected return justifies its risk.
• Performance Evaluation: Fund managers and analysts employ the CAPM to evaluate the performance of managed portfolios. By comparing a portfolio's actual returns against the returns predicted by the CAPM for its level of risk, they can assess whether the manager generated alpha (excess returns)³⁴.
• Regulatory Settings: Regulatory bodies, such as the Securities and Exchange Commission (SEC), often consider concepts akin to the cost of capital when evaluating regulated industries or reviewing public offerings. While not always directly applying CAPM as a rule, the underlying principles of risk and return are fundamental to their assessments of fair returns and capital allocation³⁰, ³¹, ³², ³³.
• Asset Valuation: The CAPM provides a theoretical basis for valuing risky securities by determining the required rate of return that investors should expect given the asset's risk profile²⁹.

Limitations and Criticisms

Despite its widespread use and theoretical significance, the Capital Asset Pricing Model faces several notable limitations and criticisms. A primary concern is its reliance on simplified assumptions that may not hold true in real-world financial markets²⁶, ²⁷, ²⁸. These assumptions include:

• Homogeneous Expectations: The CAPM assumes all investors have the same expectations regarding asset returns and risks²⁵. In reality, investors possess diverse information and form different expectations.
• Efficient Markets: The model assumes perfectly efficient markets where information is freely available and instantly reflected in prices, and there are no transaction costs or taxes²³, ²⁴. This ideal scenario is rarely observed.
• Risk-Free Rate Assumption: The existence of a truly risk-free asset that investors can borrow and lend at is often debated, as government bonds, while low-risk, still carry some level of inflation risk or interest rate risk²².
• Market Portfolio Definition: The CAPM requires a "market portfolio" that includes all risky assets in the world, in proportion to their market value. This theoretical construct is impossible to observe or replicate in practice²⁰, ²¹.
• Beta Stability and Explanatory Power: Empirical tests have often found that beta alone does not fully explain the cross-section of stock returns, leading to the identification of other factors that influence returns, such as company size and value¹⁷, ¹⁸, ¹⁹. Economists Eugene Fama and Kenneth French, for example, argued that "the failure of the CAPM in empirical tests implies that most applications of the model are invalid". Their research and that of others led to the development of multi-factor models that attempt to address these shortcomings¹⁴, ¹⁵, ¹⁶.

Capital Asset Pricing Model vs. Arbitrage Pricing Theory

The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) are both significant asset pricing models used in finance, but they differ fundamentally in their assumptions and approach to explaining asset returns.

While the CAPM provides a straightforward and intuitive framework for understanding risk and return, its reliance on a single market factor and restrictive assumptions has led to empirical challenges⁹, ¹⁰, ¹¹. The APT, developed by Stephen Ross in 1976, offers a more flexible alternative by incorporating multiple macroeconomic or industry-specific factors that influence asset returns⁷, ⁸. Despite APT's ability to potentially reflect reality more accurately by considering multiple risk sources, the CAPM remains widely taught and used due to its simplicity and clear derivation.

FAQs

What is beta in the context of CAPM?

Beta (β) in the Capital Asset Pricing Model is a measure of a security's volatility relative to the overall market. A beta of 1 means the security's price moves with the market. A beta greater than 1 means it's more volatile, and less than 1 means it's less volatile.⁶

Why is the risk-free rate important in CAPM?

The risk-free rate is a crucial component because it represents the return an investor can expect from an investment with no risk. It forms the baseline for the expected return, with additional return required only for bearing systematic risk.⁵

Can CAPM be used for individual stocks?

Yes, the Capital Asset Pricing Model can be used to estimate the expected return for individual stocks, assuming their beta accurately reflects their sensitivity to market movements. However, its accuracy for individual stocks can be limited due to its simplifying assumptions.⁴

What is the main difference between systematic and unsystematic risk in CAPM?

Systematic risk, also known as market risk, is the non-diversifiable risk inherent in the broad market that affects all assets. Unsystematic risk, or specific risk, is unique to a particular asset and can be reduced or eliminated through portfolio diversification.³ The CAPM posits that only systematic risk is compensated with a risk premium.

Does 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 in the overall market. It assumes that unsystematic (or specific) risk can be eliminated through adequate diversification and therefore does not require compensation.¹, ²