Capital Asset Pricing Model explained
Many theories have been written about investing, such as the core-satellite strategy or the modern portfolio theory, but also the Capital Asset Pricing Model .
You may have heard of the Capital Asset Pricing Model, also known as CAPM , but you don’t know what it actually means? This blog aims to explain this model in an understandable and practical way. After reading this, you will understand the basic idea of this calculation tool for financial analysis and stock valuation.
What does the Capital Asset Pricing Model actually entail?
The CAPM (Capital Asset Pricing Model) is a concept in the investment world. This model can be used to calculate how much return an investor should expect when making an investment based on the risk he/she takes.
This model was developed independently by several economists (John Lintner, Jan Mossin, William Sharpe and Treynor) and is based on the famous portfolio theory of economist Harry Markowitz. The CAPM is based on the market equilibrium and the degree of profitability of the available financial assets. The risks of these assets are taken into account when calculating the cost price of a security or an entire investment portfolio .
The Capital Asset Pricing Model predicts the risk of an asset by distinguishing between systematic risk and unsystematic risk. Systematic risk arises from the general environment that we cannot control, such as a series of economic, social and/or political factors. Systematic risk is specific to a particular company or industry.
The CAPM thus provides a financial balance of the diverse spectrum of financial assets. Among other things, the interaction of supply and demand determines the prices of these assets, taking into account both the degree of profitability of the asset and the assumed risk.
Some background on the CAPM
To better understand CAPM, we will return to Harry Markowitz’s portfolio theory (or ‘modern’ portfolio theory), which is based on both the risk and return of financial investments. In this theory, Markowitz shows the advantages of diversifying such investments in order to minimize the associated risks.
The idea behind this diversification was to spread financial resources across different industries such as: construction, industry, technologies, health, natural resources, etc. Markowitz called this whole thing ‘a portfolio’. Furthermore, he assumed that ‘the more diversified the portfolio, the better to take on the associated risks’.
Portfolio theory thus emphasizes the value of balanced investments within the diversification of the portfolio, while this causes the price decline to fluctuate. The modern portfolio method seeks to diversify investments in various markets and periods in order to absorb and reduce the fluctuations in the overall profitability of the portfolio, and thus the risk.
However, the influence of the Capital Asset Pricing Model has taken a step forward by maximizing the return of each stock and thus achieving a more profitable portfolio. In this way, the Capital Asset Pricing Model builds the optimal portfolio by determining with the greatest accuracy the investment percentages in each asset.
Thanks to this track record, the CAPM becomes more powerful for companies that want to protect themselves from the systematic risk factors that can occur.
Formula of the Capital Asset Pricing Model
The CAPM is used to calculate the price of an asset and/or a portfolio. For individual assets, the Security Market Line (or SML) is used – this symbolizes the expected return of all assets in a given market as a function of undiversifiable risk and its relationship to expected return and systematic risk ( beta) . Its purpose is to show how the market should estimate the value of an individual asset relative to the market as a whole.
Below is a practical presentation of the CAPM formula so that the meaning of each symbol becomes clear and you can easily calculate the price/value of an asset:
E(ri) = rf + βim (E(rm) – rf)
- E(ri)stands for the expected return on money on an asset i.
- βim stands for beta (the amount of risk related to the market portfolio), or also: βim = Cou (ri, rm),
and also Var (rm) - (E(rm) – rf) stands for the market risk premium – this is the additional return that investors require to be able to invest in risky assets.
- (rm) represents the market return.
- (rf) stands for the return on risk-free assets: this is usually used on a bond with a comparable term to the effective life of a financial asset being evaluated. With systematic risk, the expected return on an asset is determined using the beta value as a benchmark.
The price of an asset
If the desired rate of return E(Ri) is calculated according to the CAPM, the future cash flows that will be generated by that particular asset can be converted into the net present (or cash) value using that figure, to determine the price of the asset.
When is an asset correctly priced? When the observed price matches the price value calculated with the CAPM. If the price is higher than the obtained valuation, the asset is overvalued. If the price is lower, the asset is undervalued.
Required return for a given asset with beta
Beta symbolizes the specific incompatible risk sensitivity of the market. Here, the market as a whole has a beta value of 1. It is almost impossible to calculate the expected return of an entire market and therefore indices such as the Dow Jones are used.
The CAPM calculates the correct and required return for discounting the cash flows that an asset will yield in the future. The risk of an asset is also taken into account. A beta greater than 1 means that the asset carries more risk than the average risk for the total market; a beta less than 1 indicates a lower risk.
For this reason, an asset with a higher beta value should be discounted at a higher rate, in order to compensate the investor for the (greater) risk that a particular asset (security) entails. This reinforces the principle that investors rely on: ‘the more risk the investment entails, the higher the required return.’
In good and favorable times, investors will take more risk and invest with a high beta, while in difficult times they will operate with a small beta value.
Risk(s) and diversification
Portfolio risk implies systematic risk – also known as undiversifiable risk. Diversifiable risk is inherent to each individual asset. This diversifiable risk can be reduced by adding assets to the portfolio that dilute each other, i.e. by diversifying the portfolio.
Systematic risk, on the other hand, cannot be minimized. A rational investor should therefore not take risks that are diversifiable. Only undiversifiable risk is compensated within the applications of the CAPM. For this reason, the required return for a given asset should be linked to the contribution that this particular asset makes to the overall risk of a portfolio.
Assumptions of the Capital Asset Pricing Model
- The CAPM makes several assumptions about both the behavior of a particular market and its investors.
- Generally speaking, investors are risk averse people – they will take on investments that involve more risk if they can achieve a higher return.
- The model is a static model, not dynamic. Investors will consider the investment for only one period, for example half a year.
- Investors only look at systematic risk. The market does not generate more or less return on assets because of non-systematic risk.
- The return on assets follows a normal, statistical distribution – mathematically, the return corresponds to a related return. The standard deviation – also called standard error – is related to the level of risk. Investors are therefore concerned about the extent to which an asset deviates from the market in which it is listed. For this reason, the beta value is used as a measure of risk.
- A market is perfectly competitive, with each investor performing a utility function. In addition, he or she also enjoys an initial allocation of wealth. Investors maximize the return on their assets relative to the market in which they are included.
- The spectrum of financial assets is a fixed and known, but also exogenous variable. This means that all investors have the same information immediately and completely free of charge. Their expectations about profitability and risk are therefore the same for each type of financial asset.
Disadvantages of the CAPM
The Capital Asset Pricing Model does not accurately explain the estimation of the return of securities. Empirical studies indicate that assets with a smaller beta value can generate a higher return than the model suggests.
This model implies that all investors have the same information and hold the same thoughts about both the risks and expected returns for each asset.
The market portfolio includes all assets and also all markets – here each asset is real for its market value. It is assumed that investors do not have a preference between markets and associated assets, and furthermore that they only choose assets based on their profile with respect to risk and return.
Conclusion
The CAPM can be used to calculate the return that can be expected from an asset to compensate for the risk that the investor has taken when investing in the market. You can consider the CAPM as the economic heartbeat when taking on investment risk, whereby investors expect a higher return on their capital. The CAP model is one of the most crucial contributions in the financial sector of companies that is subject to the changing systematic risk factors of a given market.
The Capital Asset Pricing Model allows the required return to be evaluated as the expected return on a financial security, just like ordinary shares of a company. A rational investor aims to optimize his return and at the same time minimize the systematic risk of that investment and thus retain and purchase the shares of a company.
The CAPM is still widely used by investors. It is a simple model for managing the returns of high(er) investment risks in the markets you want to invest in.
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