Capital Asset Pricing Model
(CAPM)
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Capital Asset Pricing Model
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12manage reaches 100.000 members |
Valuing stocks, securities, derivatives and/or assets by relating risk and expected return. Explanation of Capital Asset Pricing Model (CAPM) of William Sharpe. |
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The Capital Asset Pricing Model (CAPM) is an economic model for valuing stocks, securities, derivatives and/or assets by relating risk and expected return. CAPM is based on the idea that investors demand additional expected return (called the risk premium) if they are asked to accept additional risk.
Description of CAPM. The Capital Asset Pricing Model is explained.CAPM was introduced by Treynor ('61), Sharpe ('64) and Lintner ('65). By introducing the notions of systematic and specific risk, it extended the portfolio theory. In 1990, William Sharpe was Nobel price winner for Economics. "For his contributions to the theory of price formation for financial assets, the so-called Capital Asset Pricing Model (CAPM)."
The CAPM model says that the expected return that the investors will demand,
is equal to: the rate on a risk-free security plus a risk premium. If the
expected return is not equal to or higher than the required return, the investors
will refuse to invest and the investment should not be undertaken.
CAPM formulaThe CAPM formula is: Expected Security Return = Riskless Return + Beta x (Expected Market Risk Premium) or: { Another version of the formula is: r-Rf = Beta x (RM - Rf) }
Beta is the overall risk in investing in a large market, like the New York Stock Exchange. Beta, by definition equals 1,00000 exactly. Each company also has a Beta. The Beta of a company is that company's risk compared to the Beta (Risk) of the overall market. If the company has a Beta of 3.0, then it is supposed to be 3 times more risky than the overall market. Beta indicates the volatility of the security, relative to the asset class.
Investing in individual securitiesA consequence of CAPM thinking is that it implies that investing in individual stocks is useless, because one can duplicate the reward and risk characteristics of any security just by using the right mix of cash with the appropriate asset class. This is why die-hard followers of CAPM avoid securities, and instead build portfolios merely out of low-cost index funds.
Assumptions of the Capital Asset Pricing ModelNote! The Capital Asset Pricing Model is a ceteris paribus model. It is only valid within a special set of assumptions. These are:
Normally, all of the assumptions mentioned above are neither valid nor fulfilled. However, CAPM anyway remains one of the most used investments models to determine risk and return.
Book: William F.
Sharpe - Portfolio Theory and Capital Markets -
Book: Harry M.
Markowitz - Mean-Variance Analysis in Portfolio Choice and Capital Markets
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Book: Mary Jackson
- Advanced modelling in finance using Excel and VBA -
Capital Asset Pricing Model Special Interest Group
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Compare with: Real Options | RAROC | Plausibility Theory | Operations Research | Strategic Risk Management | Relative Value of Growth | Cost of Equity | Cost of Capital
Return to Management Hub: Decision-making & Valuation | Finance & Investing
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| ● Pete (USA) | US Treasury Bills | "Indeed Anna, US treasury bills or government bonds were always considered to be risk-free. The reason behind this was originally that our US economy was so strong and the country so big and solid. In the last decade or so this changed and the reason became that we all agreed that we would consider the risk to be zero (even if we had some doubts already). In the last couple of years we still kept to this agreement even if we knew things had changed, because nobody was willing to accept the consequence (a system crisis). Now that we have the crisis it is obvious that the old paradigm no longer holds: US Treasury bills can no longer be considered risk-free." |
| ● Pereira (Portugal) | Can Beta be zero ? | "Assuming a Beta=0 is the same as to say that the r=Rf. Then, the security under valuation has the same expected earnings as a risk free asset. Finally, the only asset with a risk free rate is assumed to be government bonds. So, saying that some asset has Beta=0 is equivalent to say that asset is risk free or is a government bond" |
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| ● CSB Nair (India) | Stock Beta =<0 | "The beta can well be 0 or negative if the expected earnngs are below the risk free rate." | |
| ● Thomas (USA) | Stocks with a negative ß | "A company with a ß of 1.000 has the same expected return rate as the risk free rate. I therefore believe that CSB Nair is incorrect: if the expected earnings are just lower than the risk free rate, then the company has a ß between 0 and 1, but not negative. Yet it is possible to imagine a company with a negative beta! This is (only) the case when its returns are counter-cyclical and move opposite to the market. Of course, the beta of most companies' stock is positive. But there are financial assets which are designed to have negative betas. For example, funds that engage exclusively in short-selling make money when the market is falling and lose when the market is rising. Including these assets in your portfolio decreases your volatility." |
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| ● Harold (Canada) | Beta of a stock | "A beta of one means the stock moves with the market: in other words when the market moves up 5% the stock moves up 5%. A stock with a beta between 0 and 1 moves with the market but to a lessor degree. Such a stock can be called a conservative investment. A stock with a beta greater than 1 is a stock which moves in the same direction as the market but it moves more than the market moves. Such a stock can be referred to as aggressive. In other words when the market moves up 5%, a stock with a Beta of 2 moves up 10%. A stock which has a negative beta moves in the opposite direction as the market. A stock with a beta of -2 declines 8% if the market goes up by 4% and conversely climbs 8% if the market falls by 4%." |
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| ● Walter (UK) | Gold | "Gold-related stocks are typically beta-negative." | |
| ● Bikash (India) | What about cash?? | "Assets with beta 0 are same as risk-free assets and have same expected return and not assets with beta 1 as Thomas believes. Can assets have negative beta? Well, I don't think so. Beta is a measure of risk and accordingly determines expected return and not the other way round. So, an asset class (say short selling) gives opposite return to market does not mean it is less risky than a risk-free return and so we would expect it to yield lesser return than risk-free rate. In fact, we would not expect any asset class to give return less than risk-free rate? would we?? No-one, not even the most risk-averse investor, need an asset class with negative beta. Yes, the ways to determine beta might give a negative value (Say for a security that have performed counter to the market in past say 2 yrs), but that is a limitation of determining beta and not that beta is negative. But yeah, I am not sure on the beta of cash....." | |
| ● Rusell Aguilar (Peru) | BETA of Peru | "How much is beta of Peru and Latinamerica, Who has the quantity. Please I need your answer for my homework, thank you." | |
| ● (Pakistan) | CAPM | "It is the theory that relates the expected return with the risk, so when we say that the beta is zero then it means that the security is risk free and then the expected return should be none too. It is impossible in fact insane to consider a security bearing no risk, other than those who come under the definition of risk free securities. An investor in the market is not for doing a picnic, rather he is there to get some return on his investment. Even a risk-averse investor cannot compromise on return. So, I think that those who are of the opinion that there can be zero risk are not actually looking the situation with the right spectacles on." | |
| ● Anna (UK) | CAPM | "Risk-free security does not necessarily mean zero return-the return will be equal to the interest rate-i.e. Government bonds with 5% return-they are considered as risk-free, but still generate 5 % return although it could be argued how much of that 5 % is real money and how much is eaten by inflation etc." |
