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The Capital Asset Pricing Model
8 Mins Read
Risky securities can be tricky to understand. The element of risk coupled with the element of uncertainty in the returns can be hard to make sense of. Fortunately, there’s an easy formula that can help you calculate the expected returns from a risky security. This is what lies at the core of the Capital Asset Pricing Model (CAPM).
The Capital Asset Pricing Model: An introduction
The Capital Asset Pricing Model is a model that is used to determine the appropriate expected rate of return from an asset, theoretically. This can be an important metric in the decision-making process when you are considering investing in an asset. The CAPM relies on several metrics such as:
- The risk-free rate of return
- The asset beta
- The market risk premium
Let’s take these metrics up one after the other and discuss what they mean. You’ve already been introduced to two of them in the previous chapters.
1. The risk-free rate of return
The risk-free rate of return is the return expected or delivered by a risk-free investment. It is denoted as Rf.
2. The asset beta
The beta or beta coefficient tells you how volatile an asset’s prices are in relation to the market’s overall volatility. It is represented as β.
3. The market risk premium
You know what equity risk premium is, right? The market risk premium is something similar. It is the excess returns generated by the market, over and above the risk-free rate of return. In other words, is the difference between the expected returns from the market (ERm) and the risk-free rate of returns (Rf).
The CAPM formula
Now that you’ve gotten a good understanding of the metrics involved in the CAPM, let’s take a look at the formula used to calculate the expected returns from an asset using this model.
ERa = Rf + βa (ERm - Rf)
ERa = Expected returns from an asset
Rf = Risk-free rate of return
βa = Beta of that asset
ERm = Expected returns from the market
(ERm - Rf) = Market risk premium
Let’s look at an example using hypothetical data to identify the expected returns from a stock A. Say you are thinking of investing in that stock. These are the relevant metrics.
- Stock beta = 1.2
- Risk-free rate of return = 2.5%
- Expected returns from the market = 8.5%
So, the expected returns from the stock (ERa), based on the CAPM formula will be:
= Rf + βa (ERm - Rf)
= 2.5% + 1.2 (8.5% - 2.5%)
= 2.5% + 7.2%
The significance of the Capital Asset Pricing Model
The CAPM and its inherent concepts can be very useful to investors. If you are considering investing in an asset, you can make use of the CAPM to evaluate the performance of that individual stock or investment option in comparison with the rest of the market. This will give you a fair idea of how good or bad that asset is likely to perform in the coming period. You can also assess how that stock or asset fits into your existing portfolio of investments.
For example, let’s say that you have an investment portfolio that has given you average returns of around 12% each year, over the past five years. And let’s say that your portfolio has a standard deviation of around 10%. This signifies the level of risk, as you’ll recall from the previous module.
Now, let’s suppose that the market has delivered average returns of around 15% over the same five years. And the market risk comes in at around 9% only. You can use the CAPM to compare your portfolio with the benchmark and rebalance it, if need be.
Since the portfolio is delivering lower returns than the market average, and poses a higher risk, you can use the Capital Asset Pricing Model to identify the stocks or assets that are pulling the returns down or increasing the risk. Then, you can reconstitute your portfolio accordingly.
The problems with the Capital Asset Pricing Model
For all its benefits, the CAPM is not without flaws either. The main issue is that the CAPM makes many assumptions, which may or may not hold good in practice. For example, the CAPM formula makes use of a stock’s beta, which essentially represents its volatility. In the CAPM, this has been directly tied to the stock’s risk. But as you’ve seen before, volatility need not always lead to risk. Favourable price movements can lead to good returns.
Another assumption in the CAPM is that the risk-free rate remains constant over any period that we take. This is not true, because the risk-free rate is prone to changes.
Like all theories and pricing models, the CAPM has both ups and downs. It’s best to take the results you get here along with any and all other information you can gather, before you make an investment decision. So, that wraps up the basics of the CAPM. Head to the next chapter to understand what unlevering beta is all about.
A quick recap
- The Capital Asset Pricing Model is a model that is used to determine the appropriate expected rate of return from an asset, theoretically.
- It makes use of metrics like the risk-free rate of return, the beta of an asset and the market risk premium.
- The CAPM formula is: ERa = Rf + βa (ERm - Rf)
- The CAPM and its inherent concepts can be very useful to investors.
- If you are considering investing in an asset, you can make use of the CAPM to evaluate the performance of that individual stock or investment option in comparison with the rest of the market.
- For all its benefits, the CAPM is not without flaws either. The main issue is that the CAPM makes many assumptions, which may or may not hold good in practice.
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