Capital Asset Pricing Model (CAPM) & its Assumptions Explained:

Capital Asset Pricing Model

What is the Capital Asset Pricing Model?

The capital asset pricing model (CAPM) describes how the pricing of securities in financial markets establishes the expected returns on capital investments. The model gives a way to evaluate risk and turn that evaluation into an estimate of equity returns.Β 

The Capital Asset Pricing Model (CAPM) shows systemic risk, which is the overall risk of investing and expected returns for assets, especially stocks.Β 

Hence, The capital asset pricing model is a tool used in the field of finance to figure out a reasonable necessary rate of return on an investment before deciding whether or not to include that investment in a diversified portfolio.Β 

CAPM Formula and Calculation:

CAPM is calculated according to the following formula:

How to Calculate CAPM?

Before understanding the CAPM, we need to know the Expected Return (ER). Here’s how we calculate the ER;

There are four (4) factors involved in calculating the expected return.

As shown above, we first need to know the risk-free rate of return. For this, simply take the yield of a country’s long-term government bond. because they are termed risk-free and an apt product to compare in such instances.

For example, the current risk-free rate for the Indian government’s 10-year bond is at 7.16%Β 

Then we have ‘Beta’.

Beta is used to measure the volatility of the market. Remember, the bond market will not be as volatile as the stock market. So, it is crucial that we know the amount of volatile risk we are taking.

If a company’s beta is 1, it has a price that is generally stable in relation to the entire stock market. If a company’s beta is greater than 1, it has a higher degree of price volatility than the market as a whole. And, if its beta is smaller than 1, it is often less volatile than the market.

ERm-Rf stands for Market Risk Premium, wherein ERm is the expected market return and Rf stands for the risk-free rate of return.

Basically, we are deducting the risk return from the non-risk return in order to find the premium we get for taking the risk.

The Capital Asset Pricing Model (CAPM) formula is used to calculate the expected return. Systematic risk, often called non-diversifiable risk, is the basis for the assumption that investors should get a risk premium. The term “risk premium” is used to describe a return that exceeds the risk-free rate. Traders want a greater reward for taking on additional risk in the form of a bigger risk premium when investing.

For example: 

Investor Mr. Pai is planning to invest in ITC Limited. The stock has an annual dividend of 3.5% (dividend yield). and a Beta of 0.75% (you can get the details for both the dividend yield and the Beta from the “MoneyControl” website). 

With a 0.75 beta, ITC Limited is less volatile than the broad market. Mr.Pai expects the market to rise 12% each year. Taking a risk-free rate of return, as given at 7.165%, we can calculate the Expected return as follows;

Company Name: ITC Limited

ERi: Expected Return on Investment (To be calculated)

Rf: Risk-Free Rate of Return – 7.16%

Beta:Β 0.75%

(ERm – Rf): Expected Market return (-) Risk-Free rate. So, 12% (-) 7.16% = 4.84%

Therefore, we can calculate ER as follows;

ER = 7.16% + 0.75 (12% – 7.16%)

ER = 10.79%

[Dividend is also used as an alternative to risk-free bonds. But, I do not consider Dividends to be risk-free, hence using the bond rates.]
Magic Formula Investing – Meaning Features & Benefits Explained:

CAPM Formula Assumptions:

The CAPM formula’s underlying assumptions have been disproven on several occasions. Two presumptions underpin modern financial theory:

Market is Efficient

The stock market is a very competitive and productive market, which means that important information about companies is quickly spread and understood by everyone.

This factor is not necessarily true. In fact, the market is always an emotional roller coaster that doesn’t value at the right price. And it is this imperfection that gives us an opportunity to make money.

Investors are Intelligent

Investors in these markets are usually smart people who aren’t willing to take more risks than they have to in order to get the return they want.

This factor is also false. An investor can never be generalized as such. Hence, we have bulls (those who predict the market to go up), bears (those who think the market will go down), and others (those who have no idea what’s going around). Also, if it were certain that all the investors participating in the market were smart, no one will make money ever!

Advantages of CAPM:

The adoption of the Capital Asset Pricing Model has several benefits, such as:

Consider Systemic Risk

Systematic risk, also called market risk, is a very important factor because it is hard to predict and, therefore, hard to control. Whereas other return models, such as the dividend discount model, ignore systematic risk (beta), the CAPM incorporates it (DDM).Β 

Diversification

A diversified portfolio will eliminate the market risk of volatility and underperformance from a certain segment that could have little to no effect on the overall portfolio performance.

How to Diversify Your Stock Portfolio

Easy to Use

The Capital Asset Pricing Model (CAPM) is a well-known return model because it is easy to calculate and test under stress.Β 

CAPM is a pure formula-based tool. Easy to implement and calculate the desired result. As a simple formula, the CAPM can be easily “stress-tested” to show a range of possible outcomes that could help people feel more confident in the rates of return they want.

Disadvantages of CAPM:

The CAPM has limitations, but so do most scientific models. Major limitations are represented in the model’s inputs and assumptions, which include:

Unrealistic Assumptions

Under the CAPM model, investors are required to make certain assumptions. If there is a change in the actual result to the assumption, the final result will cause disagreements.

For instance, in our earlier example, we made an estimation regarding the expected market return to be 12%.

As we all know, the stock market is not linear; hence, at times, a 12% market rise may not be possible. In such a case, a reduced estimation is required. Such a change will impact the final return.

Risk-free rate

There are four underlying assumptions in CAPM, one of which is not grounded in reality. This notion that investors can borrow and lend with no risk is unreal. Investors on their own can’t get loans (or make loans) at the same rates as the federal government. Because of this, the model’s minimum necessary return line may be flatter (provide a lower return) than the actual line.

Proxy Beta

In order to apply the CAPM to evaluate an investment, businesses will need to discover a beta that accurately represents the project or investment in question. A replacement beta is required rather frequently. But picking one that does a good job of evaluating the investment is hard and could manipulate the results.

Build Investment Portfolio from Scratch:

Understanding the Capital Asset Pricing Model (CAPM):

When taking into account the arguments against the CAPM and the underlying assumptions that underpin its application to portfolio creation, its potential use may be hard to fathom. Even though the CAPM has its flaws, it may still be useful as a tool for figuring out how likely our investments are to come true and for making comparisons.

The Capital Asset Pricing Model (CAPM) and the efficient frontier may be utilized by investors to compare the performance of their portfolio or individual stocks to that of the market as a whole. Take, for instance, the case of an investor whose portfolio has averaged a 10% annual return over the past three years with a 10% annualized standard deviation of returns (risk). However, the market as a whole has averaged a 10% return over the past three years with an 8% risk.

In light of this information, investors may want to rethink their investment strategy and consider selling any holdings that aren’t performing as expected. An investor can enhance returns by making adjustments to the portfolio if the assets that are causing negative returns or substantially increasing risk are discovered.

As a result, the CAPM has played a role in the growth of indexing, the practice of constructing a portfolio of shares designed to replicate a market or asset class. That’s because, according to the CAPM, the only way to beat the market’s return is to take on a more calculated risk (beta).

Conclusion:

Investors may benefit from familiarising themselves with the ideas underlying CAPM and the related efficient frontier in order to make more informed decisions about which stocks to include in a portfolio.Β 

To establish whether an asset is priced properly, the CAPM applies the ideas of the current portfolio theory. It is predicated on unrealistic assumptions about the nature of investors, the distribution of risks and returns, and the basis of the market.Β 

Disclaimer: All the information on this website is published in good faith and for general information purposes only.

Also read:

Build Investment Portfolio from Scratch:
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Is Buying A Home A Good Investment?
Financial Independence, Retire Early (F.I.R.E)
Investment Plans & How to Attain them?

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