Capital Asset Pricing Model (CAPM)

An estimation of the CAPM and the Security Market Line (purple) for the Dow Jones Industrial
Average over 3 years for monthly data.

In finance, the capital asset pricing model (CAPM) is used to determine a theoretically
appropriate required rate of return of an asset, if that asset is to be added to an already
well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into
account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or
market risk), often represented by the quantity beta in the financial industry, as well as the
expected return of the market and the expected return of a theoretical risk-free asset.

The model was introduced by Jack Treynor (1961, 1962), William Sharpe (1964), John Lintner
(1965) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz
on diversification and modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly
received the Nobel Memorial Prize in Economics for this contribution to the field of financial
economics.
The Security Market Line, seen here in a graph, describes a relation between the beta and the
asset's expected rate of return.

The formula
The CAPM is a model for pricing an individual security or a portfolio. For individual securities,
we make use of the security market line (SML) and its relation to expected return and
systematic risk (beta) to show how the market must price individual securities in relation to
their security risk class. The SML enables us to calculate the reward-to-risk ratio for any
security in relation to that of the overall market. Therefore, when the expected rate of return
for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual
security in the market is equal to the market reward-to-risk ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and by rearranging
the above
equation and solving for E(Ri), we obtain the Capital Asset Pricing Model (CAPM).

where:

 is the expected return on the capital asset

 is the risk-free rate of interest such as interest arising from government bonds

 (the beta) is the sensitivity of the expected excess asset returns to the expected excess
market

returns, or also ,

 is the expected return of the market

 is sometimes known as the market premium (the difference between the

expected market rate of return and the risk-free rate of return).

 is also known as the risk premium

Restated, in terms of risk premium, we find that:
which states that the individual risk premium equals the market premium times β.

Note 1: the expected market rate of return is usually estimated by measuring the
Geometric Average of the historical returns on a market portfolio (e.g. S&P 500).

Note 2: the risk free rate of return used for determining the risk premium is usually the
arithmetic average of historical risk free rates of return and not the current risk free rate of
return.

For the full derivation see Modern portfolio theory.

Security market line

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula.
The x-axis represents the risk (beta), and the y-axis represents the expected return. The
market risk premium is determined from the slope of the SML.

The relationship between beta and required return is plotted on the securities market line
(SML) which shows expected return as a function of. The intercept is the nominal risk-free
rate available for the market, while the slope is the market premium, E(Rm)− Rf. The
securities market line can be regarded as representing a single-factor model of the asset
price, where Beta is exposure to changes in value of the Market. The equation of the SML is
thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a

reasonable expected return for risk. Individual securities are plotted on the SML graph. If the
security's expected return versus risk is plotted above the SML, it is undervalued since the
investor can expect a greater return for the inherent risk. And a security plotted below the
SML is overvalued since the investor would be accepting less return for the amount of risk
assumed.

Asset pricing

Once the expected/required rate of return, E(Ri), is calculated using CAPM, we can compare
this required rate of return to the asset's estimated rate of return over a specific investment
horizon to determine whether it would be an appropriate investment. To make this
comparison, you need an independent
estimate of the return the security based on either fundamental or technical analysis
outlook for
techniques, including P/E, M/B
etc.
Assuming that the CAPM is correct, an asset is correctly priced when its estimated price is
the same as the present value of future cash flows of the asset, discounted at the rate
suggested by CAPM. If the
observed price is higher than the CAPM valuation, then the asset is overvalued
undervalued (and the estimated price is below the CAPM valuation). When when SML, this
the asset does not lie on the also suggest mis-pricing. Since the expected could at time t
return of the asset is

, a higher expected return than what CAPM suggests indicates that

Pt is
too low (the asset is currently undervalued), assuming that at time t + 1 the asset returns to
the CAPM suggested price.

The asset price P0 using CAPM, sometimes called the certainty equivalent pricing formula, is a
linear relationship given by

where PT is the payoff of the asset or portfolio.

Asset-specific required return

The CAPM returns the asset-appropriate required return or discount rate—i.e. the rate at
which future cash flows produced by the asset should be discounted given that asset's
relative riskiness. Betas exceeding one signify more than average "riskiness"; betas below
one indicate lower than average. Thus, a more risky stock will have a higher beta and will be
discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at
a lower rate. Given the accepted concave utility function, the CAPM is consistent with
intuition—investors (should) require a higher return for holding a more risky asset.

Since beta reflects asset-specific sensitivity to non-diversifiable, i.e. market risk, the arket as a
whole,
by definition, has a beta of one. Stock market indices are frequently used as local proxies
for the
market—and in that case (by definition) have a beta of one. An investor in a large,
diversified portfolio (such as a mutual fund), therefore, expects performance in line with the
market.
Risk and diversification

The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, an
unsystematic risk
which is also known as idiosyncratic risk or diversifiable risk. Systematic risk refers to the risk
common to
all securities—i.e. market
Unsystematic risk is the risk associated individual assets.
risk.
with
Unsystematic risk can be diversified away to smaller levels by including a greater number of
assets in the portfolio (specific risks "average out"). The same is not possible for systematic
risk within one market. Depending on the market, a portfolio of approximately 30-40
securities in developed markets such as UK or US will render the portfolio sufficiently
diversified such that risk exposure is limited to systematic risk only. In developing markets a
larger number is required, due to the higher asset volatilities.

A rational investor should not take on any diversifiable risk, as only non-diversifiable risks
are rewarded within the scope of this model. Therefore, the required return on an asset, that
is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio
context—i.e. its contribution to overall portfolio riskiness—as opposed to its "stand alone
riskiness." In the CAPM context, portfolio risk is represented by higher variance i.e. less
predictability. In other words the beta of the portfolio is the defining factor in rewarding the
systematic exposure taken by an investor.

The efficient frontier

The (Markowitz) efficient frontier. CAL stands for the capital allocation line.

The CAPM assumes that the risk-return profile of a portfolio can be optimized—an optimal
portfolio displays the lowest possible level of risk for its level of return. Additionally, since
each additional asset introduced into a portfolio further diversifies the portfolio, the optimal
portfolio must comprise every asset, (assuming no trading costs) with each asset value-
weighted to achieve the above (assuming that any asset is infinitely divisible). All such
optimal portfolios, i.e., one for each level of return, comprise the efficient frontier.

Because the unsystematic risk is diversifiable, the total risk of a portfolio can be viewed as beta.
The market portfolio

An investor might choose to invest a proportion of his or her wealth in a portfolio of risky
assets with the remainder in cash—earning interest at the risk free rate (or indeed may
borrow money to fund his or her purchase of risky assets in which case there is a negative
cash weighting). Here, the ratio of risky assets to risk free asset does not determine overall
return—this relationship is clearly linear. It is thus possible to achieve a particular return in
one of two ways:

1. By investing all of one's wealth in a risky portfolio,

2. or by investing a proportion in a risky portfolio and the remainder in cash (either borrowed or
invested).

For a given level of return, however, only one of these portfolios will be optimal (in the sense
of lowest risk). Since the risk free asset is, by definition, uncorrelated with any other asset,
option 2 will generally have the lower variance and hence be the more efficient of the two.

This relationship also holds for portfolios along the efficient frontier: a higher return portfolio
plus cash is more efficient than a lower return portfolio alone for that lower level of return.
For a given risk free rate, there is only one optimal portfolio which can be combined with
cash to achieve the lowest level of risk for any possible return. This is the market portfolio.

Assumptions of CAPM

All investors:

1. Aim to maximize economic utilities.

2. Are rational and risk-averse.
3. Are broadly diversified across a range of investments.
4. Are price takers, i.e., they cannot influence prices.
5. Can lend and borrow unlimited amounts under the risk free rate of interest.
6. Trade without transaction or taxation costs.
7. Deal with securities that are all highly divisible into small parcels.
8. Assume all information is available at the same time to all investors.

Further, the model assumes that standard deviation of past returns is a perfect proxy for the
future risk associated with a given security.
Problems of CAPM

 The model assumes that either asset returns are (jointly) normally distributed random
variables or that active and potential shareholders employ a quadratic form of utility. It is,
however, frequently observed that returns in equity and other markets are not normally
distributed (high peak and fat tail). As a result, large swings (3 to 6 standard deviations
from the mean) occur in the market more frequently than the normal distribution
assumption would expect.
 The model assumes that the variance of returns is an adequate measurement of risk. This
might be justified under the assumption of normally distributed returns, but for general
return distributions other risk measures (like coherent risk measures) will likely reflect the
active and potential shareholders' preferences more adequately. Indeed risk in financial
investments is not variance in itself, rather it is the probability of losing: it is asymmetric
in nature.
 The model assumes that all active and potential shareholders have access to the same
information and agree about the risk and expected return of all assets (homogeneous
expectations assumption).
 The model assumes that the probability beliefs of active and potential shareholders
match the true distribution of returns. A different possibility is that active and potential
shareholders' expectations are biased, causing market prices to be informationally
inefficient. This possibility is studied in the field of behavioral finance, which uses
psychological assumptions to provide alternatives to the CAPM such as the
overconfidence-based asset pricing model of Kent Daniel, David Hirshleifer, and
Avanidhar Subrahmanyam (2001).
 The model does not appear to adequately explain the variation in stock returns.
Empirical studies show that low beta stocks may offer higher returns than the model
would predict. Some data to this effect was presented as early as a 1969 conference in
Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either
that fact is itself rational (which saves the efficient-market hypothesis but makes CAPM
wrong), or it is irrational (which saves CAPM, but makes the EMH wrong
– indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market).
 The model assumes that given a certain expected return, active and potential
shareholders will prefer lower risk (lower variance) to higher risk and conversely given a
certain level of risk will prefer higher returns to lower ones. It does not allow for active
and potential shareholders who will accept lower returns for higher risk. Casino gamblers
pay to take on more risk, and it is possible that some stock traders will pay for risk as
well.
 The model assumes that there are no taxes or transaction costs, although this
assumption may be relaxed with more complicated versions of the model.
 The market portfolio consists of all assets in all markets, where each asset is weighted by
its market capitalization. This assumes no preference between markets and assets for
individual active and potential shareholders, and that active and potential shareholders
choose assets solely as a function
 of their risk-return profile. It also assumes that all assets are infinitely divisible as to the
amount which may be held or transacted.
 The market portfolio should in theory include all types of assets that are held by anyone
as an investment (including works of art, real estate, human capital...) In practice, such a
market portfolio is unobservable and people usually substitute a stock index as a proxy
for the true market portfolio. Unfortunately, it has been shown that this substitution is not
innocuous and can lead to false inferences as to the validity of the CAPM, and it has
been said that due to the inobservability of the true market portfolio, the CAPM might
not be empirically testable. This was presented in greater depth in a paper by Richard
Roll in 1977, and is generally referred to as Roll's critique.
 The model assumes just two dates, so that there is no opportunity to consume and
rebalance portfolios repeatedly over time. The basic insights of the model are extended
and generalized in the intertemporal CAPM (ICAPM) of Robert Merton, and the
consumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.

CAPM assumes that all active and potential shareholders will consider all of their assets and
optimize one portfolio. This is in sharp contradiction with portfolios that are held by
individual shareholders: humans tend to have fragmented portfolios or, rather, multiple
portfolios: for each goal one portfolio — see behavioral portfolio theory and Maslowian
Portfolio Theory.

Formulas:
1. Expected return = R¯7 = Σ Pi × Ri
= Probability1 x Return1 + Probability2 x Return2 + …. + Probabilityn x Returnn
2. Variance = σi 2 = Σ Pi (Ri − R¯ )2

3. Standard deviation = SD (Ri ) = σi= √Variance

4. Covariance = Cov (RÆ , RB ) = σÆB = Σ Pi [(RÆ − R¯¯Æ¯) × (RB − R¯¯B¯) ]
5. Correlation = ρÆB = Cov (RA,RB)
σA × σB

6. Portfolio return= RP =Σ Wi × Ri = WB × RB + WS × RS
7. Portfolio Expected return= E(RP) =Σ Wi × E(Ri) = WB × E(RB) + WS × E(RS )
8. Portfolio variance = σ2P = (WÆσÆ)2 + (WBσB)2 + 2 × WÆ × WB × σÆB
= (WÆσÆ)2 + (WBσB)2 + 2 × WÆσÆ × WBσB × ρÆB

9. Portfolio standard deviation = σP= √Var (Portfolio)

10.Portfolio risk = βi = Cov(Ri
2
,RM)
σ (RM )

11.Portfolio βP = Σ Wiβi
12.CAPM: Expected return of equity = Ri = Rƒ + βi × (RM − RF )