CAPM-An Overview

No matter how much you diversify your investments, some level of risk will always exist. So investors
naturally seek a rate of return that compensates for that risk. The capital asset pricing model (CAPM)
helps to calculate investment risk and what return on investment an investor should expect.

Systematic Risk vs. Unsystematic Risk

The capital asset pricing model was developed and presented by the financial economist (and later,
Nobel laureate in economics) William Sharpe, in his book Portfolio Theory and Capital Markets
published in 1970. His model starts with the idea that individual investment contains two types of risk:
• Systematic Risk – These are market risks—that is, general perils of investing—that cannot be
diversified away. Interest rates, recessions, and wars are examples of systematic risks.
• Unsystematic Risk – Also known as "specific risk," this risk relates to individual stocks. In more
technical terms, it represents the component of a stock's return that is not correlated with
general market moves.
Modern portfolio theory shows that specific risk can be removed or at least mitigated through
diversification of a portfolio. The trouble is that diversification still does not solve the problem of
systematic risk; even a portfolio holding all the shares in the stock market can't eliminate that risk.
Therefore, when calculating a deserved return, systematic risk is what most plagues investors.
CAPM evolved as a way to measure this systematic risk. Sharpe found that the return on an individual
stock, or a portfolio of stocks, should equal its cost of capital.

The Capital Asset Pricing Model (CAPM) in summary describes the relationship between systematic
risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for
pricing risky securities and generating expected returns for assets given the risk of those assets and
cost of capital.
CAPM's starting point is the risk-free rate–typically a government bond. A premium is added, one that
equity investors demand as compensation for the extra risk they accrue. This equity market premium
consists of the expected return from the market as a whole less the risk-free rate of return. The equity
risk premium is multiplied by a coefficient that Sharpe called "beta."
As stated above CAPM evolved as a way to measure systematic risk. Sharpe found that the return on
an individual stock, or a portfolio of stocks, should equal its cost of capital. The standard formula for
CAPM is as follows:
Ra=Rrf+βa∗(Rm−Rrf) where: Ra=Expected return on a security; Rrf = Risk-free rate
Rm=Expected return of the market; βa=the beta of the security; (Rm−Rrf) = Equity market premium

According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's relative
volatility–that is, it shows how much the price of a particular stock jumps up and down compared with
how much the entire stock market jumps up and down. If a share price moves exactly in line with the
market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by
10% and fall by 15% if the market fell by 10%.
Beta is found by statistical analysis of individual, daily share price returns in comparison with the
market's daily returns over precisely the same period.
Beta, compared with the equity risk premium, shows the amount of compensation equity investors
need for taking on additional risk. If the stock's beta is 2.0, the risk-free rate is 3%, and the market rate
of return is 7%, the market's excess return is 4% (7% - 3%). Accordingly, the stock's excess return is 8%
(2 x 4%, multiplying market return by the beta), and the stock's total required return is 11% (8% + 3%,
the stock's excess return plus the risk-free rate).
What the beta calculation shows is that a riskier investment should earn a premium over the risk-free
rate. The amount over the risk-free rate is calculated by the equity market premium multiplied by its
beta. In other words, it is possible, by knowing the individual parts of the CAPM, to gauge whether or
not the current price of a stock is consistent with its likely return.

This model presents a simple theory that delivers a simple result. The theory says that the only reason
an investor should earn more, on average, by investing in one stock rather than another is that one is
mispriced. Not surprisingly, the model has come to dominate modern financial theory. But does it
really work?
The big problem point is beta. Differences in betas over a longer period did not explain the
performance of different stocks. The linear relationship between beta and individual stock returns
also breaks down over shorter periods of time. These findings by professors Eugene Fama and
Kenneth French seem to suggest that CAPM may be wrong.
While some studies raise doubts about CAPM's validity, the model is still widely used in the investment
community. Although it is difficult to predict from beta how individual stocks might react to particular
movements, investors can probably safely deduce that a portfolio of high-beta stocks will move more
than the market in either direction, or a portfolio of low-beta stocks will move less than the market.

• Main assumptions of the CAPM: All investors:

1) have homogeneous expectations (same expected return, volatility and correlations
for every security)
2) can lend and borrow unlimited amounts at the risk-free rate of interest
3) can short any asset, and hold any fraction of an asset
4) plan to invest over the same time horizon
5) investors only care about the expected return an d the volatility of their
investments
• Main predictions of the CAPM: The CAPM assumptions imply that all investors:
1) will always combine a risk free asset with the market portfolio
2) will have the same portfolio of risky assets (the market portfolio)
3) agree on the expected return and on the expected variance of the market portfolio
and of every asset
4) agree on the expected MRP and on the beta of every asset
5) agree on the market portfolio being on the minimum variance frontier and being
mean-variance efficient
6) trading volume of financial markets will be very small

The CAPM is based on many unrealistic assumptions. It is true that “all interesting models involve
unrealistic simplifications”… nevertheless, investor’s community still continue using it for several
reasons:
1) Beta is simple and it is used in the real world
2) If one does not use beta then what is there?” “No substitute is available so far. There are
no better alternatives”. There is no other satisfactory tool in finance for the purpose.

The Bottom Line

The capital asset pricing model is by no means a perfect theory. But the spirit of CAPM is correct. It
provides a useful measure that helps investors determine what return they deserve on an investment,
in exchange for putting their money at risk on it.
The CAPM equation
The CAPM equation links together risk and the required return for a share. It shows, for example, that
the return a rational investor would require on a particular share, R(ri), is a function of the share’s
market or systematic risk (beta), βi, and a risk premium to compensate for investing in the risky
market. Thus, the higher the risk, the higher the return the investor will require a vice-versa.
Simply stated, the underlying precept of the CAPM is that the expected return on a security is
composed of two elements as follows:

Expected return, E(r) = a risk-free interest rate + a risk premium

Using the capital asset pricing model (CAPM) this relationship is expressed more formally as:
E(ri) = rf + βi (ERm – Rf) where,
• E(ri) = required return on asset/share i
• Rf = risk-free rate of return
• βi = beta coefficient for asset/share i
• ERm = expected market return, that is the return expected on the market portfolio of share.

As it is seen above, the CAPM equation can be split into two segments:
1. The risk-free rate of return, Rf; and
2. The risk premium, βi (ERm – Rf)
We will discuss the risk-free rate of return Rf, first.

The CAPM graph – the security market line (SML)

Having now had some practice in using the CAPM to calculate the expected returns you will have
noticed that the CAPM equation is in fact a straight-line equation. Conventionally the equation for a
straight line is usually given as: y = mx + c.
When the CAPM equation is shown in graph form, the resultant straight line is referred to as the
security market line (SML). It is the line which exhibits the positive relationship (correlation) between
the systematic risk of a security and its expected return.
On the security market line (SML) the risk-free rate, Rf, is a constant and represents the vertical
intercept, i.e., the point where the SML crosses the vertical axis; it is equivalent to the constant c in
the straight-line equation above.

The co-ordinate x represents the systematic or market risk of the share as measured by its beta, βi,
and co-ordinate y represents the expected market return. Observe that the slope or gradient of the
line, a, is represented by the market risk premium (ERm – Rf), and indicates the level of risk aversion.
The SML represents the level of return expected in the market for each level of the share’s beta
(market risk), thus the risk-return trade-off for the share can be plainly seen as in Figure (below).

Interpreting the security market line (SML): A few comments about the SML will facilitate its
interpretation. First, notice that the beta associated with the risk-free security is 0, reflecting the
security’s freedom from risk and its immunity from changes in the market return. Second, point M on
the SML represents the market portfolio. The return on the market portfolio (i.e., the average return
from all securities on the entire market or a proxy index) is given by ERm and its corresponding level of
risk is shown by m, where  = 1.0.
APT – Model
The APT model was first described by Steven Ross in an article entitled The Arbitrage Theory of Capital
Asset Pricing, which appeared in the Journal of Economic Theory in December 1976. The Arbitrage
Pricing Theory assumes that each stock's (or asset's) return to the investor is influenced by several
independent factors like inflation, foreign exchange, market interest rates.
The basic difference between APT and CAPM is in the way systematic investment risk is defined. CAPM
advocates a single, market-wide risk factor for CAPM while APT considers several factors (as stated
above) which capture market-wide risks.
The Arbitrage Pricing Theory (APT) is a theory of asset pricing that holds that an asset’s returns can be
forecasted with the linear relationship of an asset’s expected returns and the macroeconomic
factors that affect the asset’s risk.

The theory aims to pinpoint the fair market price of a security that
may temporarily be incorrectly priced. The theory assumes that
market action is less than perfectly efficient always, and therefore
occasionally results in assets being mispriced – either overvalued or
undervalued – for a brief period of time. However, market action
should eventually correct the situation, moving price back to its fair
market value. To an arbitrageur, temporarily mispriced securities
represent a short-term opportunity to profit virtually risk-free.

The APT suggests that investors will diversify their portfolios, but
that they will also choose their own individual profile of risk and
returns based on the premiums and sensitivity of the
macroeconomic risk factors. Risk-taking investors will exploit the
differences in expected and real return on the asset by using
arbitrage.

It describes a world in which investors behave intelligently by diversifying, but they may choose their
own systematic profile of risk and return by selecting a portfolio with its own peculiar array of betas.
It allows a world where occasional mispricing occur. Investors constantly seek information about these
mispricings and exploit them as they find them…

The APT model states the risk premium of a stock depends on two factors:
• The risk premiums associated with each of the factors
• The stock's own sensitivity to each of the factors; similar to the beta concept
Risk Premium as per APT = [b(1) x (r factor(1) - rf)] + [b(2) x (r factor(2) - rf)]... + [b(n) x (r factor(n) - rf)]
Beta multiplied by {differences between expected return(r) and real return (rf)}

If the expected risk premium on a stock were lower than the calculated risk premium using the formula
stated, then investors would sell the stock. If the risk premium were higher than the calculated value,
then investors would buy the stock until both sides of the equation were in balance. (Arbitrage is the
term used to describe how investors could go about getting this formula, or equation, back into
balance.)
The theory describes the method of bringing a mispriced asset in line with its expected price. An
asset is considered mispriced if its current price is different from the predicted price as per the
model. The fundamental logic of APT is that investors always indulge in arbitrage whenever they
find differences in the returns of assets with similar risk characteristics.