Capital Asset Pricing Model
(CAPM)

Valuing stocks, securities, derivatives and/or assets by relating risk and expected return. Explanation of Capital Asset Pricing Model (CAPM) of William Sharpe.

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 decomposes a portfolio's risk into systematic risk and specific risk. Systematic risk is the risk of holding the market portfolio. When the market moves, each individual asset is more or less affected. To the extent that any asset participates in such general market moves, that asset entails systematic risk. Specific risk is the risk which is unique for an individual asset. It represents the component of an asset's return which is not correlated with general market moves.

According to CAPM, the marketplace compensates investors for taking systematic risk but not for taking specific risk. This is because specific risk can be diversified away. When an investor holds the market portfolio, each individual asset in that portfolio entails specific risk. But through diversification, the investor's net exposure is just the systematic risk of the market portfolio.

CAPM formula

The CAPM formula is:

Expected Security Return = Riskless Return + Beta x (Expected Market Risk Premium)

or:
r = Rf + Beta x (RM - Rf)

{ Another version of the formula is: r-Rf = Beta x (RM - Rf) }

where:
- r           is the expected return rate on a security;
- Rf         is the rate of a "risk-free" investment, i.e. cash;
- RM       is the return rate of the appropriate asset class.

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 securities

A 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 Model

Note! The Capital Asset Pricing Model is a ceteris paribus model. It is only valid within a special set of assumptions. These are:

Investors are risk averse individuals who maximize the expected utility of their end of period wealth. Implication: The model is a one period model.
Investors have homogenous expectations (beliefs) about asset returns. Implication: all investors perceive identical opportunity sets. This means everyone has the same information at the same time.
Asset returns are distributed by the normal distribution.
There exists a risk free asset and investors may borrow or lend unlimited amounts of this asset at a constant rate: the risk free rate.
There is a definite number of assets and their quantities are fixated within the one period world.
All assets are perfectly divisible and priced in a perfectly competitive marked. Implication: e.g. human capital is non-existing (it is not divisible and it can't be owned as an asset).
Asset markets are frictionless and information is costless and simultaneously available to all investors. Implication: borrowing rate equals the lending rate.
There are no market imperfections such as taxes, regulations, or restrictions on short selling.

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 -

Book: Mary Jackson - Advanced modelling in finance using Excel and VBA -

Capital Asset Pricing Model Forum (16)

How to Use CAPM for Project Analysis?
"How do I use CAPM to gauge / decide whether to take up a project or not?
If you can, please give an illustration. How superior is CAPM as compared to WACC?"

Question - CAPM and Beta
"The beta of stock A is 0,8.
The risk free rate is 6%.
The market risk premium is 8,5%.
Assume the CAPM theory holds. What is the expected return of stock A? Can somebody help me with how this question is solved. Thanks..."

CAPM is Irrelevant to Use
"Remember CAPM will not be optimal to use because it is based on a lot of assumptions, which can't be true in a real market. CAPM is just a benchmark for us."

What is Beta? Explanation and a Few Remarks
"1. Beta is a risk indicator, not a rate of return indicator.
2. Beta with no risk is 0 (used to be treasory bond).
3. Beta of 1, means a firm has the same risk of the market
4. Beta of 1 means the firm will have the same variation (standard deviation) level of the market but not the same correlation.
5. The correlation is the fact that a firm variation is at the same time of the market.
6. If the Beta is smaller than 1, this mean the firm will have smaller variation (in return) than the market.
7. We used to say that higher risk means higher rate of return. This is a global assumption, but a firm can have a higher return and a smaller risk (smaller variation)."

CAPM Model and Calculating the Inflation Rate?
"Can CAPM help us in calculating the inflation rate and in taking the investment decision? Need an ilustration on the this subject."

Raw Beta vs Adjusted Beta
"While calculating cost of equity via CAPM method, which beta one should use. Raw beta or adjusted beta and why?"

Calculating Beta of Portfolio after Portfolio Change
"Please help me to solve this question:
You have $2 million portfolio consisting of a $100,000 investment in each of 20 different stock. The portfolio has a beta equal to 1.1. You are considering selling $100,000 worth of one stock which has a beta equal to 0.9 and using the proceeds buy another stock which has beta equal to 1.4. What will be the new beta of your portfolio following this transaction?"

(Strategic) Cost Management
"What is strategic cost management how it is different from cost management?"

Return on Market in CAPM
"We substract Rf from RM. Does that mean RM (return on market) in the formula also includes Rf i.e. risk free return? But that is not the case as entire RM is risky. Please share your views."

Why Sharp Increase in the Calculation for Betas
"What was the cause of the sharp increase in the calculation for betas for the metals and mining industry over the past two years?"

Calculating Company Beta
"How do we find beta for a company?"

CAPM usage by Fund Managers
"What is the relevance of the capital asset pricing model (CAPM) to a fund manager in the equity markets? How is it being used?"

Application of Capital Asset Pricing Model in Pakistan
"I would like to know how companies in Paskistan use the CAPM model... What are the benefits and demerits???"

Are US Treasury Bills still Zero Beta?
"The books say that beta can be zero for absolutely risk-free stocks. US Treasury Bills are generally perceived to be such assets as well as other governments' bonds. Considering the present economic turmoil, I have doubts that this theory will hold. I don't know about negative beta :)"

More CAPM Assumptions
"In this model another assumption is that the number of assets are fixed in a portfolio. But this is a confusing thing as well, because it neglects the concept of marginality i.e. the overall change due to the increase of one asset in a portfolio."

Can Beta of a Stock be 0? And can Beta be Negative?
"Question on CAPM: I know that in the CAPM Model the Beta for a stock can be less than one. If the company has a Beta of 0.33, then it is supposed to be 3 times less risky than the overall market. But can Beta also be zero? And can it be negative?"

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