The Capital asset pricing model (CAPM) was developed in the mid-1960. The model was generally been attributed to William Sharpe, but John Lintner and Jan Mossin also made similar independent deprivations as such the model is often known as Sharpe-Lintner-Mossin (SLM) Capital Asset Pricing Model. The CAPM explains the relationship that should exist between the securities' expected return and their risk in terms of mean and standard deviation about security returns. The CAPM is a direct extension of the portfolio models developed by Markowitzand Sharpe.
Using a set of simplifying assumptions, the CAPM is an equation that expresses the equilibrium relationship between a security's or portfolio's expected return and its systematic return. The Capital Assets Pricing Model (CAPM) attempts to measure the risk of a security in the portfolio sense. It considers the required rate of return of security on the basis of its contribution to total portfolio risk. The core idea of the CAPM is that only undiversifiable risk is relevant to the determination of expected return on any asset. Since the diversifiable risk can be eliminated, there is no reward for it. In fact, the CAPM can be used to examine the risk and return of any type of capital asset such as individual security, an investment project, or a portfolio of assets/investment. However for the time being, the CAPM is being discussed here with reference to risk and return of a security only.
Assumptions of CAPM: The CAPM is based upon several assumptions as follows:
The investors are basically risk averse and diversification is needed to reduce the risk.
All investors want to maximize the wealth and therefore choose a portfolio solely on the basis of risk and return assessment.
All investors can borrow or lend an unlimited amount of funds at risk-free rate of interest.
All investors have identical estimates of risk and return of all securities.
All securities are perfectly divisible and liquid and there is no transaction cost or tax.
The security market is efficient and purchase and sales by a single investor cannot affect the prices. This also means that there is a perfect competition in the market.
All investors are efficiently diversified and have eliminated the unsystematic risk. Thus, only the systematic risk is relevant in determining the estimated return.
S M
Average Expected return, r, 19% 17%
Standard Deviation .089 .0395
Variance .00792 .00156
Covariance (S, M) .00204
Now,
β = COV (S, M) = .00204 = 1.3
σ2M .00156
It may be noted that both the σ and β are the measures the risk. However, the two measures are different. While σ is a measure of total risk, the β is relative index of systematic risk. The beta measure, β, is more relevant for the pricing of securities and other assets. The returns expected by investors should logically be related to systematic risk as opposed to total risk. Securities with higher systematic risk should have higher expected returns. In fact, the more responsive the price of a security is to changes in the market, the higher will be its beta factor.
After discussing and calculating the beta factor, β, the CAPM can be expressed as follows:
RS = IRF + (RM - IRF ) β
where RS = The expected return from a security / asset.
IRF = The risk-free interest rate.
RM = The expected return on market portfolio.
β = the beta factor, a measure of systematic risk of the
Security/asset.
The portfolio that contains all the securities in the economy is called the market portfolio, and it plays a crucial role in CAPM. The above equation states that the expected return on any security or portfolio (RS) is the sum of two components: (1) the risk-free interest rate, IRF, and (2) the market risk premium, (RM - IRF) β which is proportional to the covariance of the security's rate of return with the market's return. The risk premium is equal to the difference between the expected market return and the risk-free interest rate multiplied by the beta factor. Evidently, the risk premium varies directly with the beta factor i.e., the systematic risk and therefore, the value of RS depends upon the beta factor, β. The higher the beta factor, the greater the expected rate of return, and RS vice-a-versa. The CAPM can also be presented as:
Expected Return = Price of Time + Price of Risk * Amount of Risk
Say, far a security IRF = 10%
RM = 17%
β = 1.3
Then,
RS = IRF + (RM - IRF) β
= .10+ (.17-.10)1.3
= .191 or 19.1%
Therefore, the security under consideration has the required rate of return of 19.1%. The average expected rate of return (in view of the probability distribution) of the security is 19%. Therefore, the security is correctly priced.
What the CAPM shows is that the expected return for a particular security depends on three things:
The pure time value of money: As measured by the IRF, this is the reward for merely waiting for your money, without taking any risk.
The reward for bearing systematic risk: As measured by market risk premium, (RM - IRF), this component is the reward, the market offers for bearing an average amount of systematic risk in addition to waiting.
The amount of systematic risk: As measured β, this is the amount of systematic risk present in a particular security, in relation to that in an average security.
The CAPM helps establishing the relationship between risk and return. The securities assets with the same risk should have the same expected rate of return. The CAPM when plotted on a graph gives a line as depicted :
The graphical version of CAPM is also known as Security market line (SML). The SML represents the relationship between beta factor and the expected rate of return f a security. The intercept at Rf is the minimum required rate of return even if the beta is 0. This is also called risk-free rate. However, with every increase in risk as shown by the rise in beta factor, the risk premium also increases and consequently the required rate of return also increases. Therefore, the risk premium is lower for a low beta factor and is higher for a greater beta factor.
Uses of CAPM
CAPM has a variety of applications. The model is helpful not only in allocation of resources for real investment but also for financial investment i.e. securities. Capital asset pricing model used for decisions relating to portfolio evaluation, capital expenditure, financing etc. The CAPM determines the cost of capital for discounting of future cash flows. CAPM is even assist in risk implications of mergers and acquisitions, product mixes and many more. CAPM has been the most widely used method in finance.
The Capital asset pricing model provides many useful insights to the finance manager to maximize the value of the firm. It shows the type of risk for which shareholders require compensation in the form of a higher risk premium, and hence, a higher return. As the finance mangers also perform the investment function on behalf of shareholders, they must keep sight of the returns shareholders except for taking risks.
Limitations of CAPM
CAPM is a useful model in dealing with the risk. However, it suffers from the following problems:
The calculation of beta factor is very tedious as lot of data is required. The beta factor can be found by examining the security's historical returns relative to the return of the market portfolio. Further, the beta factor may or may not reflect the future variability of returns. One cannot expect the beta factor to be constant over time. It must be updated frequently.
The assumptions of CAPM are hypothetical and are impractical. For example, the assumption of borrowed and lending at the same rate is imaginary and not practical. In practice the borrowing rates are higher than the lending rates.
The required rate of return specifically by the model can be viewed only as a rough approximation of the required rate of return.
Conclusion
The capital asset pricing model has been employed in a wide variety of academic and institutional applications such as measuring portfolio performance, testing of market efficiency, identifying under and overvalued securities, capital budgeting etc. Apart the model have also been used in business by analyst, researcher's and firms.
Although the CAPM has been dominant over the last 30 years and is the basis for modern capital market theory, but with the emergence of new equity markets around the world during the last few years, accumulating research has increasingly created doubt on the model's ability due to many cases arising where the model is not able to explain the correct movement of assets return.Despite its limitations and shortcomings, the CAPM model is a popular tool in the investment analysis. The simplicity of the model towards description of the equilibrium has made it quite popular among the users even today. But due to its limitations and is more based on beta, the researchers and practitioners have began to look to more multi-beta models that encompasses the CAPM and address its shortcomings. In the multi beta model market risk is measured relative to a set of risk factors that determine the behavior of asset returns, whereas the CAPM model gauge risk only relative to the market return. What i believe is CAPM have significantly contributed to the step forward in security pricing theory, it does have some deficiencies when applied in practice and for which an extended CAPM should be applied or have to look for a new better model which should not have any deficiencies.
