What is Capital Asset Pricing Model (CAPM)?

What is CAPM?

The Capital Asset Pricing Model (CAPM) describes the association between the anticipated return and the risks of investing in a security. It represents the fact that the expected return on an asset is equal to the risk-free return rate plus a premium for taking the risk that is based on the beta of the security.

Assessing the CAPM requires proper knowledge of systematic and unsystematic risks.

  • Systematic risks are the general dangers, which apply to all forms of investment. For example, inflation rate, Wars, recessions, etc., are systematic risks.

  • Unsystematic risks, on the other hand, show the specific dangers associated with investing in a particular stock or equity. The unsystematic risks are not taken as threats that are shared by the general market.

CAPM deals with the systematic risks on securities, therefore predicting what could go wrong with given investments.

Formula for CAPM

CAPM formula is given by,

$$\mathrm{𝑅_{𝑎} = 𝑅_{𝑓} + 𝐵_{𝑒} × (𝑅_{𝑚} − 𝑅_{𝑓} )}$$

The different factors of this equation are −

  • $𝑅_{𝑎}$ = Expected dividend from investment

  • $𝑅_{𝑓}$ = Risk-free rate

  • $𝐵_{𝑒}$ = Beta factor of the underlying transaction

  • $(𝑅_{𝑚} − 𝑅_{𝑓})$ = Current market risk premium

This CAPM formula takes the returns into accounts, which the investor receives due to their risk-taking ability and extended duration of the investment. The beta factor here is calculated as a risk along with the current market conditions.

Therefore, if the risks associated with an investment are lower than the present circumstances, the beta value of the formula will be less than 1. For the risk that equals the market conditions, the beta will be equal to 1. Lastly, if the risk is more than the established market norm, the ‘Be’ value in the formula will be greater than 1.

How does CAPM Benefit Investors?

There are certain advantages of the CAPM model of risk-reward evaluation for investors.

  • Assumption of a diversified portfolio − The CAPM model assumes that an investor always maintains a diversified investment portfolio, which can eliminate the unsystematic risks.

  • Convenient and simple − This model is built in a way that is extremely easy to use. The calculations enable investors to decide one way or the other while it comes to choosing equities.

Drawbacks of CAPM

While CAPM is used by investors worldwide, it does have some drawbacks as well.

  • Risk-free rates tend to change frequently − The CAPM considers the short-term government securities to generate a risk-free premium for the rate used in CAPM calculations. This risk-free rate, however, is highly volatile, changing within a span of just a few days.

  • A risk-free rate is not a real factor − Individual investors are unable to lend or borrow at the same rates as the government does. Therefore, assuming a complete risk-free rate for calculation is not practical. Therefore, the correct return from an investment may go lower than what is predicted by the CAPM model.