Capital Asset Pricing Model (CAPM)

Reviewed by Anjaneyulu | Updated on Aug 27, 2020

Introduction

The Capital Asset Pricing Model (CAPM) refers to the relationship between systemic risk, especially stocks, and expected to return on the assets. The CAPM is widely used for pricing the risky securities and for generating expected returns on assets due to the risk of such assets and capital costs.

Understanding

The formula to calculate the expected return of an asset and its risk is as follows:

ERi=Rf + βi (ERm - Rf)

ERi = Expected return of investment Rf = Risk-free rate βi = Beta of the investment (ERm - Rf) = Market risk premium

Investors expect cost and time value of the investment to be balanced. Within the CAPM formula, the risk-free rate accounts for the time value of assets. The other elements of the CAPM formula account for an increased risk faced by the investor.

The beta of an investment is a calculation of how much value the investment would bring to a market-like portfolio. When a stock is more volatile as compared to the market, the beta will be higher than one. When a stock has a beta value less than one, the formula implies the risk of a portfolio is lowered.

The beta of a stock is then compounded by the market risk premium, which is the estimated return over the risk-free average from the market. Further, the risk-free rate is added to the stock beta product and the market risk premium.

The result would provide an investor with the appropriate return or discount rate they may use to calculate an asset's value.

The CAPM formula aims to determine whether a stock is reasonably priced as compared to its expected return with its risk and the time value of assets.

Issues with CAPM

There are several theories behind the CAPM formula which have been shown not to hold necessarily.

The modern financial theory is based on two hypotheses:

  1. Stock markets are highly competitive and productive (i.e., relevant company knowledge is easily and uniformly spread and absorbed).

  2. These markets are dominated by sensible, risk-averse investors trying to maximize satisfaction from their investment returns.

Given these problems, the CAPM formula is still commonly used because it is straightforward and makes investment alternatives easy to compare the investment alternatives.