CAPM - Capital Asset Pricing Model

From Bogleheads

The Capital Asset Pricing Model (CAPM)[note 1] determines a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, and given that asset's non-diversifiable risk.

The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the symbol beta (β), as well as the expected return of the market and the expected return of a theoretical risk-free asset.

Risk and return

In general, investors expect higher returns from higher risks. Conversely, investors will accept lower returns to reduce risk.

An asset has two types of risk: systematic and unsystematic.

Unsystematic risk is the risk of an individual security or portfolio; systematic risk is the risk inherent in the whole market. In a portfolio, unsystematic risk is effectively "random noise" in its volatility of returns. By diversifying (adding many securities), the random noise component eventually averages out to zero (the definition of random noise). The standard deviation of the portfolio's return also falls as the number of securities in the portfolio increases.

If there are enough assets in a portfolio to ensure that diversification cannot affect the performance, the portfolio's return volatility matches that of the overall market.

Risk that diversification cannot reduce is systematic risk. The degree to which a portfolio's return varies relative to that of the overall market measures the amount of systematic volatility.

Beta

Beta (β) is calculated by taking the risk-adjusted return Ri (return over the risk-free rate, also known as the "Risk-adjusted" or "excess" return) over a time period of the individual asset (i) (or portfolio) divided by the risk-adjusted return (Rm) of the market. Simplifying further, β is the slope of the line of the returns over this period.[2][3]

β = Slope of the line = Ri / Rm.

For example: If an equity X has a return of 8%, the expected return of the market m is 10%, and the risk-free rate is 2%:

β = 0.75 = Ri / Rm = (8% - 2%) / (10% - 2%)

More comprehensively, beta (β) describes the relationship between the returns of a security or portfolio (an asset) and the returns of the market as a whole; it combines the correlation of the asset's returns and the market's returns with the relative volatility of those returns:

β = cov(rA, rM) / σM2 = ρ(rA, rM) × (σA / σM)
where:
  • rA is the set of returns of the asset
  • rM is the set of returns of the market
  • σM2 is the variance of the returns of the market
  • cov(rA, rM) is the covariance between the returns of the asset and the returns of the market
  • ρ(rA, rM) is the correlation between the returns of the asset and the returns of the market
  • σA is the standard deviation of the returns of the asset
  • σM is the standard deviation of the returns of the market

Market risk (β) is calculated using historical returns for both the asset and the market, with the market portfolio being represented by a broad index, for example the S&P 500 index or the Russell 2000 index.

Capital Asset Pricing Model

Assumptions

The Capital Asset Pricing Model (CAPM) tries to quantify the relationship between the beta of an asset and its corresponding expected return. It makes several assumptions:

  1. Investors care only about expected returns and volatility of returns. Therefore, it maximizes expected returns for any given level of expected volatility of returns.
  2. All investors have the same beliefs about the risk/reward trade-offs in the market.
  3. There is only one risk factor common to a broad-based market portfolio, called systematic market risk. It assumes that investors hold diversified portfolios. As a result, the CAPM model states that if an asset's beta is known, it can predict the corresponding expected return.

Model description

There are three areas of interest:

1. β = 0: An asset that has no volatility of returns (no risk) does not have returns that vary with the market, and therefore has a beta of zero and an expected return equal to the risk-free rate.
2. β = 1: An asset that moves with a volatility of returns exactly equal to the market's has a beta of one. In other words, the returns are perfectly positively correlated. By definition, its expected return is equal to the market's expected return:
E(rA) = E(rM)
3. β > 1: An asset that experiences greater swings in periodic returns than the market, which, by definition, has a beta greater than one. This asset is expected to earn better than market returns to compensate for this extra risk.

Making a lot of generalizations leads to the CAPM model:

E(rA) = rf + βA(E(rM) - rf)
where:
  • E(rA) is the expected return of the asset
  • rf is the risk-free rate
  • E(rM) is the expected return of the market portfolio

(Note: the quantity E(rM) - rf, which is the expected excess return of the market above the risk-free rate, is called the market risk premium, often abbreviated MRP.)

The general idea of CAPM is that investors should be compensated in two ways: time value of money, and risk.

  • The time value of money is represented by the risk-free (rf) rate in the formula, and compensates investors for placing money in any investment over a period of time.
  • The other part of the formula represents risk, and calculates the amount of compensation the investor needs for taking on additional risk. It does this by using an estimate of risk, (βA), and multiplying by the MRP, (E(rM) - rf).

An asset is expected to earn the risk-free rate plus a reward for bearing risk as measured by that asset’s beta. The figure below shows this predicted relationship between beta and expected return – this line is called the Security Market Line.

CAPM.png

For example, a stock with a beta of 1.5 would be expected to have an excess return of 15% in a time period where the overall market beat the risk-free asset by 10%.

The CAPM model is used for pricing an individual security or a portfolio. For individual securities, the security market line (SML) and its relation to expected return and systematic risk (beta) shows how the market must price individual securities in relation to their security risk class.

Because the CAPM predicts expected returns of assets or portfolios relative to risk and market return, it can also be used to evaluate the performance of active fund managers. The difference is "excess return", which is often referred to as alpha (α). If α is greater than zero, the portfolio lies above the Security Market Line.

Shortcomings of the CAPM model

The CAPM model has several shortcomings. Criticisms include incorrectly predicting results compared to realized returns, and the effects of other risk factors. Its assumption that there is a single risk factor limits the model's usefulness.

Eugene Fama and Kenneth French found that on average, a portfolio’s beta explains about 70% of its actual returns. For example, if a portfolio is up 10%, about 7% of the return can be explained by the advance of all stocks and the other 3% is the result of other factors not related to beta. This observation led to the development of the Fama and French three-factor model.

Other uses of CAPM

CAPM is also used to cost equities in applications other than investing. For example, the Weighted average cost of capital (the rate that a company is expected to pay to finance its assets) uses CAPM to calculate the cost of equity:

Weighted Average Cost of Capital (for a firm)
= (% of the firm in debt, at market value) × Kd[cost of debt] × (1 - marginal tax rate for the firm)
+ (% of the firm in equity, at market value) × Ke[cost of equity]

(Note: this formula assumes the firm has only debt and common equity; that is, no preferred equity.)

Ke is estimated using the CAPM:
Ke = rf + βe(E(rM) - rf)
where:
  • Ke is the cost of equity
  • rf is the risk-free rate of return
  • E(rM) is the expected return of the market
  • E(rM) - rf is the market risk premium and is held to be, normally, between 4% - 5% (real) per year (the last 110 years of UK data, similar to the US)

(Another method of calculating Ke uses the Dividend discount model.)

Notes

  1. William F. Sharpe won the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1990 for his pioneering work on the CAPM.[1]

See also

References

  1. "The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1990, Press release". NobelPrize.org. October 16, 1990. Retrieved October 20, 2023.
  2. Bogleheads forum post: "Re: Suggestions for the Wiki", moshe. April 19, 2016.
  3. "How to Calculate Beta (with Pictures)". wikihow. Retrieved October 20, 2023.

External links