Understanding the Capital Asset Pricing Model

Through the CAPM model, experts can theoretically determine the required rate of an asset for getting the maximum returns and to diversify portfolio.

• What is Capital Asset Pricing Model?
• General Assumptions of CAPM
• Applications of Capital Asset Pricing Model
• Calculating Expected Returns on Security Using CAPM
• Example 
• Advantages
• Disadvantages

What is Capital Asset Pricing Model?

Capital Asset Pricing Model (CAPM) is a methodology used by experts to theoretically represent the behavior of financial markets. This helps experts to quantify the risk and in turn, estimate the expected returns on equities. 

It refers to the relationship between expected returns on assets and risks associated with investing. Through CAPM, experts can assess such risks, price securities, and determine expected returns on these assets. Instead of only using the CAPM, it should be used with other methods to determine the useful cost of equity calculations.

According to the Capital Asset Pricing Model:

Expected return on securities = risk-free return + risk premium (based on the beta of security)

Now, let us understand the above terminologies.

• In theory, the risk-free rate of return indicates the minimum rate of return earned by an investor from another investor holding zero risk (For example government bonds). 
• Risk premium refers to the difference between the returns on equity and the risk-free rate of return. This premium indicates the rate of return that is greater than the risk-free rate. Investors want a higher risk premium while investing in high-risk investments. 

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General Assumptions of CAPM

The model takes the following assumptions:

1. Investors should consider the returns and risks involved in the security while deciding whether to invest in it or not. 
2. No qualitative factors related to stock can influence the decision-making of an investor.
3. Investors are risk averse and they maximize their utility.
4. No single investor holds the power to influence the prices and returns of stocks. 
5. There is no taxation on returns earned on investments.
6. Investors hold diversified portfolios that eliminate unsystematic risk amongst stock holdings.

Applications of Capital Asset Pricing Model

Even if you understand this concept in theory, it is more important to understand the applications of this pricing model. 

1. Portfolio Management

Through this pricing model, investors can build a diversified portfolio for building portfolio management to manage their risks. When the investor optimizes the portfolio return relative to the risk, it will exist on the curve called the ‘efficient frontier’ on a graph. 

Through this graph, investors can understand the reason behind the requirement for greater expected risks for greater expected returns. When the portfolio exists on the Capital Market Line (CML), it is considered to be an ideal portfolio for the market.

2. Evaluating expectations

For example, an investor is planning to add a stock to his portfolio with a $50 share price. The advisor uses the CAPM for justifying the share price with an x% discount rate. The investment manager of that advisor can compare this information with past performance of the company to evaluate whether x% is a reasonable expectation. 

3. Comparing stock performance

Investors can use the pricing model for comparing the performance of a stock with the market. Through this evaluation, they can further assess their portfolio to decide whether to keep a holding or not. Once they can identify the riskier holdings, they can redo their portfolio for better returns. 

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Calculating Expected Returns on Security Using CAPM

Through the below-given formula, experts can evaluate whether the stock is fairly valued when its time value of money and risk are compared with the expected returns. 

Expected return on a security (ERS) = Risk- free rate + (Beta of security x (Market Risk premium)

Here:

The beta of security indicates the volatility of returns or risk on stocks. This is reflected by measuring the changes in the stock price relative to the overall market. If a company has 1.2 Beta, it indicates that the stock has 120% of volatility of the market average. When Beta is equal to 1, expected returns on security = average market return. If the Beta is -1, the security will have a perfect negative correlation with market. In case Beta is greater than 1, this indicates that the security is riskier than the market. 

The market risk premium is the difference between the risk-free rate and the expected returns of the market. The market premium is directly proportional to the volatility of assets and the market. Higher the volatility, the higher the market risk premium.

Example To Understand the Pricing Model

Let us consider two examples to understand the calculation. 

Example 1

Suppose, a stock trades on the NSE with current yields on a 10-year treasury as 3%. The average excess historical returns for Indian stocks have been 5%. The beta for this security is 1.25. Then the expected return on this security will be:

Expected returns on the security/stock= Risk free rate + [Beta x Market Risk Premium]

= 3% + [1.25 x 5%]

= 9.3%

Example 2

An investor is confused about whether to invest in ABC or XYZ stocks based on the results of the CAPM model. ABC has got 8.6% as returns with 0.95 as its beta value. XYZ stocks have 7.7% returns and 1.2 beta value. The risk-free return is 4.6%. As per the formula, 

Expected returns on stocks = Risk-free return + [Beta x (Returns on the stock -Risk free return)] 

Expected returns on ABC = 4.6% + [0.95% x (8.60% – 4.60%)] = 8.4%

Whereas, expected returns on XYZ = 4.6% + [1.2% x (7.70% – 4.60%)] = 8.32%

Since the expected returns on ABC are higher than returns on XYZ, the investor should invest in ABC. 

Advantages of Capital Asset Pricing Model

Following are the advantages of the pricing model:

1. It only considers systematic risk thus eliminating any confusion regarding individual security risk or general market risk. 
2. Experts use this pricing model to calculate the weighted average cost of capital which helps in calculating the cost of financing through various resources. 
3. It is a simple model that can be used for comparison between equities of different countries. 

Disadvantages of the Pricing Model

The pricing model does have the following limitations:

1. The simplicity of the model is its major drawback, which is in contradiction is the reason for its popularity. The model is unrealistically simplified which overlooks components required for making useful models. 
2. According to CAPM, investors can borrow and lend at risk-free rates. This is an unattainable situation in real circumstances. For instance, an individual investor will not be able to borrow or lend at the same rate as government bodies.
3. The accurate calculation of the Beta value is a difficult and time-consuming process. To overcome this issue, proxy beta value is used to speed up return calculation. However, this reduces accuracy. 

Conclusion

CAPM formula is used by many investors. There are mainly two reasons behind its popularity. First, due to its simplicity and second is its ability to provide comparison amongst securities. This methodology is also useful for investors to accurately determine the expected dividends. The results of this formula allow investors to evaluate their portfolios to get better returns. Overall, the pricing model helps investors in making better decisions when choosing security worthy of investment.