Capital Asset Pricing Model (CAPM) is a model based on the proposition that any stocks

required rate of return is equal to the risk-free rate of return plus a risk premium that reflects
only the risk remaining after diversification. It provides a general framework for analyzing risk-
return relationships for all types of assets. CAPM uses only one part of the total risk called the
systematic risk, in evaluating the risk-return relationship.

The total risk (previously measured by standard deviation) can be separated into two major
components:

Diversifiable risk – also called unsystematic risk or company risk. This is the part of the
security’s risk caused by factors unique to a particular firm. This type of risk can be diversified
away because it represents essentially random events. Sources of diversifiable or
unsystematic risk include lawsuits, strikes, company management, marketing strategies and
research and development programs, operating and financial leverage and other events that
are unique to a particular firm. Because these events are random, their effects on a portfolio
can be eliminated by diversification.

 Undiversifiable risk – also called systematic or market risk. This is the part
of a security’s risk caused by factors affecting the market as a whole. This
type of risk cannot be eliminated by diversification because it affects all firms
simultaneously. Some companies are sensitive than others to factors that
1affect systematic risk. Hence, systematic risk is the only relevant risk and
is affected by such factors as wars, inflation, interest rates, business cycles,
fiscal and monetary policies and therefore cannot be eliminated by
diversification.

Effect of Diversification on Systematic and Unsystematic Risk

The effect of diversification can be shown on the figure below:
Figure 8. Effect of diversification
It can be observed that as the number of stocks held in a portfolio increases, the diversifying
effect of each additional stock on unsystematic risk diminishes. However, one should be
careful in selecting stocks to be included in the portfolio taking into consideration their
correlations with one another. If the investor chooses stocks with correlations with one another
and with low stand-alone risk, the portfolio’s risk will decline faster rather than if stocks will be
randomly added.

If increasing the number of stocks held in a portfolio, then is it advisable for an investor to just
hold a portfolio consisting all stocks? Probably not, because of the following reasons:

 It entails high administrative costs and commissions would be more

than offset the income for individual investors.
 Index fund can be used for diversification and many individuals can
and do get broad diversification through these funds.
 Some people believe that they can pick stocks that will “beat the
market” so they buy them rather than the broad market.
 Some people can, through superior analysis, beat the market; so they
find and buy undervalued stocks and sell overvalued ones.

Capital Asset Pricing Model Illustrated

The CAPM uses beta as a measure of risk. It is a model developed to help determine a share’s
required rate of return for a given level of risk. It can be computed as:

Required rate of return = risk-free rate + risk premium

If an investor chooses to invest his money, then he must postpone consumption. Then at what
rate of return will an investor be persuaded to postpone consumption and invest his money
instead?If the investor takes no risk whatsoever, but merely postpones consumption, he
wanted to be compensated for the wait plus an additional return for any inflationary
pressures (an inflation premium).
If the investor demands a 3% return to postpone consumption, and another 2% to cover the
expected rate of inflation, he will require 5% rate of return which is a risk-free rate. In actual
market scenario, we can consider treasury securities as a good proxy or benchmark for a
riskless asset because there is no default risk. At this point we can say that, risk-free rate is
composed of:
 real rate that excludes any inflationary expectations; and
 inflation premium that equals the expected inflationary rate.
To continue the illustration, an investor would get to move from a risk-free asset if he will be
given an additional compensation that he requires for investing in a risky asset. The additional
compensation required referred as risk premium can be computed as follows:

Risk Premium = (Price per unit of Risk) (Beta)

The price per unit of risk is the difference between return on the market and the risk-free rate,
that is:

Price per unit of risk = Return on the Market – Risk-free Rate

Therefore, the formula to compute for the required rate of return under CAPM, can be
expressed as follows:
ri = rf+ (rm – rf) (bi)
Where:
ri= required (or expected) return on security, i
rf=expected risk-free rate of return
rm= expected return on the market portfolio
bi= beta coefficient of security, i

Illustration 1. Suppose a particular stock has a risk-free rate of 5%, a rate of return
on the market of 12% and a beta coefficient (quantity of risk) of 1.5. What would be
the investor’s required rate of return?
Solution: ri = rf+ (rm – rf) (bi)
ri = 5% + (12% - 5%) (1.5)
ri = 5% + 10.5%
ri = 15.5%

The investor would require a risk premium of 10.5%. Thus, the required rate of
return is 15.5%.

Illustration 2.Using the same illustration, except that the beta coefficient is2.0,
what would be the required rate of return?
Solution: ri = rf+ (rm – rf) (bi)
ri = 5% + (12% - 5%) (2)
ri = 5% + 14%
ri = 19%

The investor would demand for a greater rate of return because of the increase in
risk. The additional compensation (risk premium) required is 14%. Thus, the
required rate of return is 19%. As can be observed, the higher the risk, the greater
would be the required rate of return.
The Beta Coefficient Concept
The risk of a stock when it is held by itself can be measured using the standard deviation of its
expected returns. However, this is not applicable if stocks are held in a portfolio. Hence, the
systematic risk can be measured by a stock’s beta coefficient.
Beta is a measure of the sensitivity of a security’s return relative to the returns of a broad-
based market portfolio securities. It measures the co-movement between a stock and the
market portfolio. The tendency of the stock to move with the market is reflected in its beta
coefficient (b), which is the measure of the stock’s volatility relative to an average stock.
An average-risk stock is defined as one that tends to move up and down in step with the
general market as measured by some index, such as PSE Index, Dow Jones Industrials, the
S&P 500 or the New York Stock Exchange Index.
An average stock generally has a beta (b) of 1.0 which means that is the market moves up by
10%, the stock will also move up by 10%; on the other hand, if the market falls by 10%, the
stock will likewise fall by 10%. Hence, a portfolio of stocks with beta of 1.0
, will move up and down with the broad market averages, and it will be just as risky as the
averages.
If the beta is equal to 0.50, the stock is only half as volatile as the market – it will riseand fall
only half as much – and a portfolio of such stocks will be half as risky as a portfolio of stocks
with beta of 1.0.
If the beta is equal to 2.0, the stock is twice as volatile as an average stock, so a portfolio of
such stocks will be twice as risky as an average portfolio. The value of such portfolio could
double – or halve – in a short time; hence, very risky.
Figure 9. Relative Volatility of Stocks A, B and C
Figure 9 presents the relative volatility of three stocks. The data below the graph assume that
in 2009 the market, defined as the portfolio consisting of all stocks, had a total return
(dividend yield plus capital gains yield) of km= 10%, and stocks A, B and C (for High, Average
and Low risk) also had returns of 10%. In 2013, the market went up sharply, and the return on
the market portfolio was km= 20%. Returns on the three stocks also went up: A soared to 30%;
B went to 20%, the same as the market; and C only went up to 15%. Now suppose that the
market dropped in 2014, and the market return was km= -10%. The three stocks’ return also
fell, A plunging to -30%; B falling to -10% while C reported 0%. Thus, the three stocks all
moved in the same direction as the market, but A was by far the most volatile; B was a volatile
as the market; and C was less volatile.
If a higher-beta-than-average stock is added to an average-beta portfolio, then the beta and
consequently, the riskiness of the portfolio will increase. Conversely, if a lower-beta-than-
average stock is added to an average-risk portfolio, the portfolio’s beta and risk will decline.
To summarize, the market risk of a stock is measured by its beta coefficient, which is an index
of the stock’s volatility. Some benchmark betas follow:
b = 0.5 : Stock is only half as volatile, or risky, as the average stock.
b = 1.0 : Stock is of average risk.
b = 2.0 : Stock is twice as risky as the average stock.

Portfolio Beta Coefficient

Portfolio beta coefficient can be computed as the weighted average of the individual
securities’ betas. The beta of the portfolio reflects how volatile the portfolio is in relation to the
market.
For example, if an investor holds P1,500,000 portfolio consisting of P500,000 invested in each
of 3 stocks and each of the stock has a beta of 0.8, then the portfolio’s beta will be:
bp = (1/3)(0.8) + (1/3)(0.8) + (1/3)(0.8)
= .8

Since the portfolio beta is lower than 1, we can safely say that this portfolio is less risky than
the market. Hence, it should experience relatively narrow price swings and have relatively
small rate of return fluctuations.

Suppose one of the existing stocks is sold and replaced by a stock with b1 = 2, what will
happen to the portfolio beta? In this case, since, one of the stocks has increased its beta, we
can expect that the portfolio beta will also increase as computed as follows:

bp = (1/3)(0.8) + (1/3)(0.8) + (1/3)(2)

= 1.2
Hence, from a portfolio beta of 0.80, it increased to 1.2 as a stock with higher beta was added
in the portfolio.

Another illustration. Calculation of Portfolio Beta

An investor decided to invest his P350,000 as follows:

Amount % Allocation Beta

Diversified Stocks P200,000 57.1% 1.00
Bonds 100,000 28.6% 0.18
Treasury bills 50,000 14.3% 0.00
Total P350,000 100.0%

The beta for this portfolio can be computed as follows:

b = (0.571)(1) + (.286)(0.18) + (.143)(0)
b = .62

With a portfolio beta of .62, a market return of 11% and a risk-free rate of 5%, an
investor can expect a return of:

ri = rf+ (rm – rf) (bi)

= 5% + (11%-5%)(.62)
= 8.7%

Security Market Line (SML)

The CAPM is expressed graphically by the security market line (SML). The security
market line represents the linear relationship between a security’s required rate of
return and its risks as measured by beta.

Figure 10. The Security Market Line (SML)

Figure 10 shows the SML and the risk-return tradeoff of Stock 1 and Stock 2. As can
be gleaned, the risk-free rate is 8% whereas the market rate of return is 14%;
therefore, the market risk premium is 6% (14%-8%). Stock 1 with a beta coefficient
of 2 would require a high risk premium of 12%; hence, its required rate of return is
20%. On the other hand, Stock 2 with a beta coefficient of 0.5 would require a low
risk premium of 3%, hence, its required rate of return is 11%.

The required rate of return computed under CAPM can also be used as a market-
based hurdle rate for the purpose of evaluating investments. A hurdle rate is the
minimum rate of return required for a project to be accepted. Hence, if an assets’
expected rate of return equals or exceeds the required return (falls on or above the
SML), as computed by CAPM, the asset is accepted; otherwise, it is rejected.

Illustration on Investment Decision based on SML

Based on the previous illustration, Stock 1 and Stock 2 have required rates of return
of 20% and 11%, respectively. Assume that the expected return for Stock 1 is 18%
and for Stock 2 is 15%. Should the investments be acquired based on the SML?

Figure 11 shows that Stock 2’s expected return of 15% is above the SML and
therefore should be acquired because it is higher than the required rate of return
(hurdle rate) of 11%. On the other hand, Stock 1 is rejected because it is expected
return is only 18% which is lower than the required rate of return of 20%. Also, based
on the graph, the expected return of Stock 1 of 18% is under the SML; hence, should
be rejected.

Figure 11. Using Security Market Line (SML) to Select Securities

Concerns About CAPM

The CAPM is based on restrictive assumptions about

investor behavior and the securities market.
 Assumptions about investor behavior include:
 Investors are risk-averse and expect to be rewarded for taking risks;
 Investors act rationally and prefer a security with the
highest return for a given level of risk, or the lowest risk
for a given level of return;
 Investors make their decisions based on a single time horizon; and
 Investors share the same expectations about
the risk and return characteristics of
securities.

1. Assumptions about the securities market include:

 All investors can borrow or lend in unlimited amounts at the risk-free
rate;
 Financial markets are frictionless in that there are no
taxes or transaction costs;
 All assets are perfectly divisible and perfectly liquid and
 Information is freely available to all investors.

CAPM’s limitation lies on the fact that some of its assumptions

do not all reflect reality. There is also greater possibility that we
may not be able to determine the average return on market
portfolio since they could be many possible bases and we may
not be able to determine which is most representative of the
market. Another concern is related to beta estimation because
the applicability and relevance of a company’s beta will depend
on the futureplans of the firm.

With these limitations, finance researchers have introduced

other asset pricing models which considers other risk factors to
the predictive relationship of risk and return other than the
market risk. These factors such as firm size and book-to-market
ratio are used along with beta as measure of market risk.