CAPM - Capital Asset Pricing Model

CAPM. An economic model for valuing stocks by relating risk and expected return. Based on the idea that investors demand additional expected return (called the risk premium) if asked to accept additional risk.

The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically appropriate required rate of return (and thus the price if expected cash flows can be estimated) of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The CAPM formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a number often referred to as beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.

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Formula

According to the CAPM, teh cost of equity, or equivalently the expected return for equity is:

Expected Return = R = Risk Free rate + b (Risk Premium)

beta coefficient

Investing 101

There is a relationship between risk and expected return.  The more you want in returns, the more risk you need to be willing to take.  But, that said...there is an expected amount of risk for any return.  Risking too much is not a sign of bravery, its a sign of stupidity.   When looking at risk and returns, you should understand the CAPM - Capital Asset Pricing Model - to estimate the cost of equity .  Within this model, you should use the T-bills rate of return as the "risk-free" rate, and then add a risk-premium.  

Asset-specific required return

The CAPM returns the asset-appropriate required return or discount rate - i.e. the rate at which future cash flows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one signify more than average "riskiness"; betas below one indicate lower than average. Thus a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. The CAPM is consistent with intuition - investors (should) require a higher return for holding a more risky asset.

Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the market as a whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for the market - and in that case (by definition) have a beta of one. An investor in a large, diversified portfolio (such as a mutual fund) therefore expects performance in line with the market.

Risk and diversification

The risk of a portfolio comprises systematic risk and unsystematic risk which is also known as idiosyncratic risk. Systematic risk refers to the risk common to all securities - i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio. (specific risks "average out"); systematic risk (within one market) cannot. Depending on the market, a portfolio of approximately 30-40 securities in developed markets such as UK or US (more in case of developing markets because of higher asset volatilities) will render the portfolio sufficiently diversified to limit exposure to systemic risk only.

A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded within the scope of this model. Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e. its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability. In other words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor.

Capital Market Line

The (Markowitz) efficient frontier

 

 

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