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FINANCE AND INVESTING

Understanding CAPM And How It Works

By CIFER | Updated 5th April 2021

The Capital Asset Pricing Model (CAPM) model is arguably the most important idea in finance as it explains and predicts pricing of single assets and portfolios. Developed my famous economist William Sharpe, CAPM describes the relationship between expected returns on assets and the systematic risk of that asset. Naturally, higher risk is a compensation for higher expected returns therefore CAPM can help investors calculate what levels of return is acceptable for any given risk. 

ASSUMMPTIONS

It is important to be aware of the assumption in which the CAPM model has been developed upon because in reality, they are not entirely reliable. 

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  1. Single Period Horizon - CAPM uses a standardised holding period to make asset comparisons easier. Periods of 12 months are typically used in the model; A 3 month return is incomparable to a 12 month return.

  2. Perfect Capital Markets - The model assumed that all assets are valued correctly and perfect information is available to all market participants. Further, perfect markets excluded transaction costs and taxes and assume investors are risk adverse and rational 

CALCULATING CAPM

Regardless of how an investor diversifies their portfolio, some level of risk will always exist; CAPM is used to set risk premiums by calculating investors risk exposure and therefore, cost of capital for investment appraisal.

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Expected Return = Risk free rate + Beta * Market Risk Premium

The risk premium ( Rm - Rf ) refers to the excess returns the asset yields over and above the market risk-free rate; it is a compensation for the increased risk the investor takes 

RISK

The model classifies an assets risk into two different types;

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  1. Systematic Risk  - This is general market risks that are not specific to the particular security and cannot be fully diversified away. Factors like interest rate decisions, political instability, law changes etc are classified as systematic risk

  2. Unsystematic Risk - This relates to the risk associated with specific investments which can be reduced via portfolio diversification. Example: Holding stocks in the same industry increases exposure through correlation; if the oil industry experienced a sudden negative shock (increase supply), all of an investors holdings would be effected in the same way.

BETA

Beta is a coefficient that measures the sensitivity of a particular asset compared against the broader market. For example; if a stock has a beta of 1.4, this would represent a 1.4% change in that stock price for every 1% move in the market index. A beta of -1 represents a perfect negative correlation against the market.

EXAMPLE OF CAPM

We will use the CAPM model to demonstrate how the expected return on a stock can be calculated given the hypothetical parameters:

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1) An American company with shares trading in the SP500

2) The risk free rate (US Gov. 10year yields) is trading at 2.5%

3) The historical excess returns in the SP500 average 7.5%

4) Beta is 1.25

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Using the CAPM formula above:

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Expected Return = 2.5 [ 1.25 * 7.5 ]

Expected return = 11.9%

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