What Is the Capital Asset Pricing Model?

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DEFINITION

The Capital Asset Pricing Model (CAPM) is a tool used extensively by finance professionals and portfolio managers to make investment decisions. It uses the factor of risk to analyze the expected returns on potential investments.

Definition and Examples of the Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a tool that uses the factor of risk to analyze potential investments for expected returns. It's used frequently by finance professionals and portfolio managers to help them make investment decisions.

CAPM was a breakthrough because it was the first model to measure the relationship between risk and return, so investors could set expectations. 

CAPM was introduced in the early 1960s as a way to calculate expected returns based on risk. CAPM represented two major innovations in financial theory, Dr. Thomas Smythe, Professor of Finance at Florida Gulf Coast University told The Balance in an email.

“First, it breaks risk into its two components: unsystematic risk (risk unique to the firm) and systematic risk (risk that all stocks are exposed to),” Smythe said. “When we diversify, we can all but eliminate each individual stock’s unsystematic risk, such that only market or systematic risk remains. Second, CAPM is very powerful in that it says that all stocks should be evaluated based on their exposure to market risk, as measured by the stock’s beta”

The CAPM is not limited to stocks, it can be used to evaluate all forms of investments. For example, portfolio managers can use CAPM to benchmark returns for the levels of risk their clients want to take on.

Investors can use CAPM to evaluate the performance of portfolio managers. Corporate finance managers use CAPM to decide on new investments based on the risks and potential returns to the shareholders.

How the Capital Asset Pricing Model Works

Capital Asset Pricing Model works by providing a formula for analysts to use to determine the expected returns of a particular asset. 

The CAPM formula is:

Expected Return = Risk Free Rate + (Market Risk Premium x Beta)

Risk-Free Rate

The U.S. Treasury six-month note or 10-year bond rate is typically used as the risk-free rate because there is virtually no risk of default, or risk of the issuer not providing the expected return.

Market Risk Premium

Market risk premium is the return investors receive above the risk-free rate, or essentially compensation for taking the risk.

The market risk premium is calculated by subtracting the risk-free rate from the expected market return of a broad index like the S&P 500. Market risk premium is then adjusted by the portfolio beta. 

Beta

The CAPM uses beta to determine the risk and expected return. Beta compares the total price changes of an individual security or portfolio to the price changes of the entire market. 

An S&P 500 index fund for example has a beta of 1, because the fund will go up or down at the same rate the stock market goes up and down. If the XYZ company stock has a beta of 1.1 it will rise or fall 10% more than the stock market. 

The betas for stocks and other investments are found by using a statistical process called linear regression.

As a hypothetical example, we can look at the actively managed ABC fund performance through the capital asset pricing model.

  • Risk-free rate: 4.64%
  • Market risk premium: 9.7%
  • ABC fund beta: 1.30
  • ABC 10-year return: 16.71%

So, with this information, you can calculate the expected return. 

  • Expected return = 4.64% + (9.7% x 1.30)

So, the expected return is 17.25%. Now you can compare that to the actual return, which was 16.71%.

Pros and Cons of the Capital Asset Pricing Model

Pros
  • Simplicity

  • Focus on systematic risk

  • Risk/return relationship

Cons
  • Only account for one factor

  • Assumptions

Pros Explained 

  • Simplicity: The CAPM formula is straightforward, and input values are usually publicly available.
  • Focus on systematic risk: CAPM only considers systematic risk. Systematic risk like inflation, wars, or natural disasters impact the entire market, and can’t be eliminated. Unsystematic risk is risk that is specific to a company, not the broader market. Unsystematic risk can be virtually eliminated by portfolio diversification.
  • Risk/return relationship: CAPM can show investors what their expectations of returns should be for a level of risk. CAPM is graphically represented by the Securities Market Line.

Cons Explained

  • Only accounts for one factor: Unlike other models like the Fama-French 3-factor model, which accounts for company size and value, the CAPM focuses only on market risk. 
  • Model assumptions: CAPM makes theoretical assumptions about the capital markets, investor behavior, and risk-free lending rates that don’t translate to the real world. For example, it assumes investors hold diversified portfolios, that they can borrow and lend at a risk-free rate, and that capital markets are perfect, meaning they don’t include taxes, transaction costs, or other potential factors.

What It Means to the Average Investor

CAPM is used extensively by portfolio managers and finance professionals. While CAPM is simple and flexible, it’s not a tool to make buy/sell decisions on individual securities. 

CAPM and the Security Market Line can help the average investor to understand the risk associated with different target levels of return for their financial plan and investment strategy.  

Key Takeaways

  • Capital Asset Pricing Model (CAPM) is a model that analysts use to measure risk and returns.
  • CAPM can be used to evaluate the performance of many investments such funds.
  • CAPM assumes investors hold diversified portfolios and that they can borrow and lend at a risk-free rate, among other assumptions.
  • Unlike other models, the CAPM does not take into account the role of a company’s size or whether it is undervalued.

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Article Sources

  1. Yale School of Management. “Chapter IV: The Portfolio Approach to Risk | William N. Goetzmann.”

  2. Columbia University. “1 Capital Asset Pricing Model (CAPM).”

  3. Society of Actuaries. “Equity Risk Premiums.”