Capital Asset Pricing Model (CAPM): Explained

What is the Capital Asset Pricing Model?

The Capital Asset Pricing Model is a financial framework that derives the estimated return on investment in a security based on the associated risk of investing in the market. The risk mentioned here is also called ‘systematic risk,’ and is unavoidable as it stems from market volatility.

The CAPM model demonstrates a linear relationship between an asset’s expected rate of return (reward) and volatility (risk). The CAPM computation uses the relationship between market volatility and this risk-free rate to arrive at this expected return. The CAPM model builds on the fact that high-risk investments also yield greater rewards.

The Capital Asset Pricing Model is used in finance to estimate the price as well as returns from investing in riskier securities. As we know what is the capital asset pricing model, let us now focus on the CAPM formula.

CAPM Formula & Calculation

The formula for calculating the expected rate of return using CAPM is as follows:

where,

ER = Expected Return on the investment

R_f = Risk-free rate

β = Market volatility of the security (can be found on any trading terminal)

R_m = Expected return of the market

Here, “(R_m – R_f)” is called the ‘market risk premium,’ which is the surplus return an investor will stand to make by holding on to the riskier security instead of holding on to risk-free security.

Now, let’s understand these terminologies in detail.

Expected Return

The expected rate of return is the percentage of return that the investor will earn on his investment throughout its lifespan. The expected return depends on the market volatility as well as the overall market’s rate of return. The risk-free rate is more or less constant and does cause any change in the ER computation.

Risk-free Rate

Theoretically, certain securities have zero risk as they are backed by the government itself and are guaranteed to not default on payments. So in India, the risk-free rate is equivalent to that of the 10-year government bond yield, which is 7.3% in March 2023. In the USA, the yield of 10-year Treasury Bills is followed. The risk-free rate depends on the country being invested in.

Beta

Beta is basically a measure of the riskiness of a stock. It does so by numerically representing the volatility of that stock’s price in comparison with the market. Since beta measures volatility relative to the market, it is also a measure of ‘market sensitivity.’ So a beta of 1 indicates that the stock will move in tandem with the market. A beta greater than 1 means that the stock will move in the same direction as the market but to a greater extent. Stocks with a beta of less than one are stabler than the market and move minimally in the same direction as the market. Stocks with negative beta indicate that they show inverse movement as compared to the market.

Market Risk Premium

When an investor makes a risky investment, it means that their portfolio is at the mercy of market volatility. But in exchange for taking more risk, the investor is commensurately awarded that more too. In such cases, the market risk premium is also higher.

CAPM Calculation – An Example

Let us better understand the Capital Asset Pricing Model formula with an example:

Let’s assume that the stock we are considering has a beta of 1.38 and the market rate of return is 14%. The yield of the 10-year govt bonds is 7.3%. Therefore, the expected return on this stock will be:

It is also worth noting that the expected return calculated using the CAPM formula is used to discount future cash flows to their present value in order to arrive at the valuation of a company. The method is known as the ‘Discounted Cash Flow’ (DCF) method of valuation.

Assumptions in the CAPM calculation

Some unrealistic assumptions are a part of the Capital Asset Pricing Model. The 3 most important ones are:

• Firstly, the use of beta in the formula means that risk is measured as a function of volatility. However, price movements in upward and downward directions carry different amounts of risk. Moreover, there is no fixed period of time that must be considered when historical volatility is determined.
• The second assumption that this model operates under is that the risk-free rate remains fixed throughout the discounting period. Any change in government bond yields will immediately change the expected rate of return. This impacts the calculation of the present value of the stock using the DCF model.
• Thirdly, all investors are not risk-averse and do not evaluate stocks over the same timeframe.

Alternatives to the Capital Asset Pricing Model

Since CAPM has found itself at the receiving end of doubts and its actual functionality, some alternative theories have been identified to replace it.

1. Arbitrage Pricing Theory (APT): APT is a pricing model that considers several factors in asset pricing. Its underlying logic is that instead of just one factor assumed by CAPM, multiple macroeconomic factors have a role to play in the pricing of the asset.
2. Fama-French 3-Factor model: This model builds on the existing CAPM model and includes size risk as well as value risk into the picture. By doing so, the model incorporates the fact that small-cap stocks invariably outperform the broader markets.

What is the International Capital Asset Pricing Model (ICAPM)?

The ICAPM further broadens the pre-existent CAPM and takes it to international investments. Calculating expected risks in the international markets adds foreign exchange risk, which does not appear in the domestic market. This is taken into consideration in the International Capital Asset Pricing Model.

Conclusion

CAPM was developed long ago in 1990 and works only to a limited extent. Since then, more sophisticated models have appeared, which encompass the various risks associated with different kinds of investments. When you use CAPM, make sure that you only make the relevant underlying assumptions and factor any additional risk that comes with your choice of investment.

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