The Capital Asset Pricing Model (CAPM) is an investment assessment formula that shines a light on the relationship between the systematic risk in a security and its estimated return. Investors use the CAPM to determine whether an investment’s expected return is the same as its risk-free return, and to determine an asset’s expected returns.
CAPM Defined
The Capital Asset Pricing Model makes the process of measuring investment return and risk more efficient, to determine whether a particular asset offers an acceptable rate of return.
CAPM is especially helpful when an investor faces significant investment risk, such as when trading equity options. The formula helps the investor determine whether the transaction has an acceptable measure of risk. By using CAPM, the investor is able to accurately assess if the potential investment return on a security is worth taking on.
Evaluating the fair value of a security is an ongoing endeavor, as investment risk factors and other variables change all the time. When those risks shift (think interest rate changes, company management changes, or a geopolitical crisis erupts, among other potential threats), investors can still use the capital asset pricing model to weigh an investment against constant risk and return variables.
Investors can factor market impactors, like interest rate flows, currency valuations, and stock market cycles, among other issues, into their CAPM analysis to better weigh risk versus return. Basically, the bigger the chance of risk, the more important CAPM becomes to investors weighing that risk against potential returns.
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What Is the CAPM Formula?
CAPM can help evaluate an investment’s viability in a time of significant market angst, by measuring three important barometers in an investment equation – risk-free return, the market risk premium, and the investment beta.
Let’s take a look at how CAPM is calculated with all three factors included.
The (capital asset pricing model) CAPM formula is represented as below:
Expected Rate of Return = Risk-Free Premium + Beta * (Market Risk Premium) Ra = Rrf + βa * (Rm – Rrf)
The calculation reflects a series of financial metrics, which taken together can offer a balanced look at a potential investment’s risk and return, with the aforementioned metrics front and center.
Risk-Free Return (Rrf)
This metric represents the value given to an investment (like a stock or commodity trading, for example) that provides return with no risk. U.S. Treasury bond, backed by the full faith and credit of the United States government, are a good example of risk-free return in action.
Since the U.S. government guarantees the bonds, and there is virtually zero chance of the U.S. defaulting on its debt obligations, Treasuries are considered among the safest investments available. That’s a big reason why risk-free return value reflects the yield delivered by a 10-year U.S. government bond.
The Market Risk Premium (Rm-Rrf)
This financial metric represents the return an investor earns – or anticipates earning – from owning a more risk-abundant portfolio. The MPA is an important component of CAPM, as it enables an investor to assess risk and decide if the market premium rate is superior to an investment in a risk-free investment like U.S. bonds.
The Beta (Ba)
Wall Street analysts rely on beta to weigh the volatility of a given security against a broader market.
For instance, an investor looking to buy 100 shares of an emerging biotech company can use beta to evaluate that investment and see how it may perform if the broader stock market turns volatile. In that scenario, that biotech stock’s beta may be 13%, which means it would trigger a 130% variation from any significant (based on the exact calculation) of any shift in the broader stock market. Beta is always equal to 1 in any market evaluation equation, meaning it’s parallel to any potential shifts in a broader market
CAPM Formula Explained
Factoring in each component to the CAPM equation, the resulting formula looks like this:
Expected return = Risk-free rate + (beta x market risk premium).
The risk-free component focuses on the time value of money, or the concept that a cash amount in present form is potentially higher than the same amount of cash down the road, primarily because of money’s current earnings potential. A CAPM formula may also factor in excess risks taken on by an investor.
Next, beta is assessed to figure out just how much risk is on the table relative to the broader market. For instance, if ABC stock offers more risk than the broader market, its beta is higher than 1 (one). A beta that is lower than 1 assumes the investment will curb portfolio risk, which may make a security more palatable to risk-averse investors.
With the beta calculated, beta is multiplied by the market risk premium, and the result (value) is added into the investment’s risk-free rate to provide the security’s estimated rate of return.
In conducting a CAPM exercise, the investor must acknowledge some level of risk in any investment, primarily in two ways.
• Loss is always possible, as common market securities like stocks, commodities, funds, or currencies may lose money, making them a depreciation risk.
• The higher level of risk in a specific security often correlates to a higher potential investment return, as history shows that specific investments carry more risks and more rewards than others (stock options and future.
Advantages to Capital Asset Pricing Model
The chief advantages to the capital asset pricing model are that it’s relatively simple and easy to use, it takes systemic risk into consideration, it has a wide range of potential uses (when other models may not do the trick, for instance), and for that reason, is often seen as a superior model to others, such as the WACC formula.
Problems with the CAPM
While the CAPM is an extremely useful tool for investors, it does have some drawbacks. One such drawback is the reliance on the risk-free rate and the beta. As such, CAPM must be constantly recalculated in order to remain useful. It also does not account for transaction costs such as taxes and fees, which could make a potential investment less favorable than the model shows.
Efficient Frontiers and the Capital Asset Pricing Model
In theory, if an investor adhered perfectly to CAPM all of their investments would exist on the efficient frontier, meaning that all returns justify the risks taken. The efficient frontier is the optimal baseline for a portfolio, Since every investment comes with some risk, it’s important to make sure that the returns correspond to the level of risk.
CAPM and the Security Market Line (SML)
The security market line, or SML, is a graphical representation of the CAPM formula, and shows expected returns for a security. Specifically, it shows the relationship between beta and expected return. When used in conjunction with the CAPM formula, investors can use the SML to try and get a sense of whether a prospective investment offers a good enough expected return when all risks are taken into account.
Practical Value of the CAPM
Many investors probably wonder if, when it comes down to it, CAPM has much practical value. While that will ultimately depend on the individual investor, it may be fair to say that the CAPM has value in that it’s widely used, and can give investors a broad or general idea of the risks and potential returns involved with a single investment. Again, it’s not the only model or formula that does that – but can be yet another tool that an investor can have in their analytical tool box.
The Takeaway
CAPM can help investors understand how the risk and return of a given investment relate to each other. Having the answer to that question can help investors make more knowledgeable portfolio decisions on an ongoing basis.
CAPM is also a fairly high-level investing concept, and one that many investors may never use or encounter. That’s not to say it doesn’t have its uses – but if you feel that it’s over your head or too advanced, you can always consult with a financial professional for guidance.
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FAQ
What are some of the assumptions built into the CAPM model?
A few assumptions built into the CAPM model are that all investors are naturally risk-averse, that investors are evaluating investments within the same time period, and that investors have unlimited capital to borrow at a relatively risk-free rate of return.
What are alternatives to the CAPM?
Some alternatives to the CAPM include arbitrage pricing theory, or APT, and the Fama-French Model. There are others out there, too, which may or may not be perfect substitutes or alternatives to the CAPM.
What is the International Capital Asset Pricing Model (ICAPM)?
The International Capital Asset Pricing Model, or ICAPM, is more or less an extension of the CAPM, and incorporates or includes international investments.
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