What Is the Capital Asset Pricing Model?

The Capital Asset Pricing Model (CAPM) 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.

Capital Asset Pricing Model - CAPM

Understanding the Capital Asset Pricing Model (CAPM)

The formula for calculating the expected return of an asset given its risk is as
follows:

ERi=Rf+βi(ERm−Rf)where

:ERi=expected return of investment

Rf=risk-free rate

βi=beta of the investment

(ERm−Rf)=market risk premium

Investors expect to be compensated for risk and the time value of money.

The risk-free rate in the CAPM formula accounts for the time value of money.
The other components of the CAPM formula account for the investor taking on
additional risk.

The beta of a potential investment is a measure of how much risk the

investment will add to a portfolio that looks like the market. If a stock is riskier
than the market, it will have a beta greater than one. If a stock has a beta of
less than one, the formula assumes it will reduce the risk of a portfolio.

A stock’s beta is then multiplied by the market risk premium, which is the

return expected from the market above the risk-free rate. The risk-free rate is
then added to the product of the stock’s beta and the market risk premium.
The result should give an investor the required return or discount rate they can
use to find the value of an asset.

The goal of the CAPM formula is to evaluate whether a stock is fairly valued
when its risk and the time value of money are compared to its expected return.

For example, imagine an investor is contemplating a stock worth $100 per

share today that pays a 3% annual dividend. The stock has a beta compared
to the market of 1.3, which means it is riskier than a market portfolio. Also,
assume that the risk-free rate is 3% and this investor expects the market to
rise in value by 8% per year.

The expected return of the stock based on the CAPM formula is 9.5%:

9.5%=3%+1.3×(8%−3%)

The expected return of the CAPM formula is used to discount the expected
dividends and capital appreciation of the stock over the expected holding
period. If the discounted value of those future cash flows is equal to $100 then
the CAPM formula indicates the stock is fairly valued relative to risk.

Problems With the CAPM

There are several assumptions behind the CAPM formula that have been
shown not to hold in reality. Modern financial theory rests on two assumptions:
(1) securities markets are very competitive and efficient (that is, relevant
information about the companies is quickly and universally distributed and
absorbed); (2) these markets are dominated by rational, risk-averse investors,
who seek to maximize satisfaction from returns on their investments.

Despite these issues, the CAPM formula is still widely used because it is
simple and allows for easy comparisons of investment alternatives.

Including beta in the formula assumes that risk can be measured by a stock’s
price volatility. However, price movements in both directions are not equally
risky. The look-back period to determine a stock’s volatility is not standard
because stock returns (and risk) are not normally distributed.

The CAPM also assumes that the risk-free rate will remain constant over the
discounting period. Assume in the previous example that the interest rate on
U.S. Treasury bonds rose to 5% or 6% during the 10-year holding period. An
increase in the risk-free rate also increases the cost of the capital used in the
investment and could make the stock look overvalued.

The market portfolio that is used to find the market risk premium is only a
theoretical value and is not an asset that can be purchased or invested in as
an alternative to the stock. Most of the time, investors will use a major stock
index, like the S&P 500, to substitute for the market, which is an imperfect
comparison.

The most serious critique of the CAPM is the assumption that future cash
flows can be estimated for the discounting process. If an investor could
estimate the future return of a stock with a high level of accuracy, the CAPM
would not be necessary.
The CAPM and the Efficient Frontier
Using the CAPM to build a portfolio is supposed to help an investor manage
their risk. If an investor were able to use the CAPM to perfectly optimize a
portfolio’s return relative to risk, it would exist on a curve called the efficient
frontier, as shown on the following graph.

The graph shows how greater expected returns (y-axis) require greater
expected risk (x-axis). Modern Portfolio Theory suggests that starting with the
risk-free rate, the expected return of a portfolio increases as the risk
increases. Any portfolio that fits on the Capital Market Line (CML) is better
than any possible portfolio to the right of that line, but at some point, a
theoretical portfolio can be constructed on the CML with the best return for the
amount of risk being taken.

The CML and efficient frontier may be difficult to define, but it illustrates an
important concept for investors: there is a trade-off between increased return
and increased risk. Because it isn’t possible to perfectly build a portfolio that
fits on the CML, it is more common for investors to take on too much risk as
they seek additional return.

In the following chart, you can see two portfolios that have been constructed
to fit along the efficient frontier. Portfolio A is expected to return 8% per year
and has a 10% standard deviation or risk level. Portfolio B is expected to
return 10% per year but has a 16% standard deviation. The risk of portfolio B
rose faster than its expected returns.

The efficient frontier assumes the same things as the CAPM and can only be
calculated in theory. If a portfolio existed on the efficient frontier it would be
providing the maximal return for its level of risk. However, it is impossible to
know whether a portfolio exists on the efficient frontier or not because future
returns cannot be predicted.

This trade-off between risk and return applies to the CAPM and the efficient
frontier graph can be rearranged to illustrate the trade-off for individual assets.
In the following chart, you can see that the CML is now called the Security
Market Line (SML). Instead of expected risk on the x-axis, the stock’s beta is
used. As you can see in the illustration, as beta increases from one to two, the
expected return is also rising.
The CAPM and SML make a connection between a stock’s beta and its
expected risk. A higher beta means more risk but a portfolio of high beta
stocks could exist somewhere on the CML where the trade-off is acceptable, if
not the theoretical ideal.

The value of these two models is diminished by assumptions about beta and
market participants that aren’t true in the real markets. For example, beta
does not account for the relative riskiness of a stock that is more volatile than
the market with a high frequency of downside shocks compared to another
stock with an equally high beta that does not experience the same kind of
price movements to the downside.

Practical Value of the CAPM

Considering the critiques of the CAPM and the assumptions behind its use in
portfolio construction, it might be difficult to see how it could be useful.
However, using the CAPM as a tool to evaluate the reasonableness of future
expectations or to conduct comparisons can still have some value.

Imagine an advisor who has proposed adding a stock to a portfolio with a

$100 share price. The advisor uses the CAPM to justify the price with a
discount rate of 13%. The advisor’s investment manager can take this
information and compare it to the company’s past performance and its peers
to see if a 13% return is a reasonable expectation.

Assume in this example that the peer group’s performance over the last few
years was a little better than 10% while this stock had consistently
underperformed with 9% returns. The investment manager shouldn’t take the
advisor’s recommendation without some justification for the increased
expected return.

An investor can also use the concepts from the CAPM and efficient frontier to
evaluate their portfolio or individual stock performance compared to the rest of
the market. For example, assume that an investor’s portfolio has returned
10% per year for the last three years with a standard deviation of returns (risk)
of 10%. However, the market averages have returned 10% for the last three
years with a risk of 8%.

The investor could use this observation to reevaluate how their portfolio is
constructed and which holdings may not be on the SML. This could explain
why the investor’s portfolio is to the right of the CML. If the holdings that are
either dragging on returns or have increased the portfolio’s risk
disproportionately can be identified, the investor can make changes to
improve returns.

Capital Asset Pricing Model (CAPM) Summary

The CAPM uses the principles of Modern Portfolio Theory to determine if a
security is fairly valued. It relies on assumptions about investor behaviors, risk
and return distributions, and market fundamentals that don’t match reality.
However, the underlying concepts of CAPM and the associated efficient
frontier can help investors understand the relationship between expected risk
and reward as they make better decisions about adding securities to a
portfolio.