Finance

A Detailed Study on Capital Asset Pricing Model (CAPM)

The capital asset pricing model is the link between risk and returns established by the security market line. It was independently invented by three scholars in the mid-1960s, William Sharpe, John Lintner, and Jan Mossin.

Meaning of CAPM model

It essentially depicts a linear relationship between some variables. The higher the beta value, the higher the risk of the security and, as a result, the higher is the expected return for investors. To put it another way, all securities are expected to provide returns that are proportional to their riskiness as evaluated by (β). This link is true not only for individual assets but for all portfolios, whether they are efficient or not.

CAPM demonstrates how risky assets are valued in a well-functioning capital market. It aids in predicting the expected return on a security or portfolio. The expected return calculated using CAPM can be used to determine whether the security earns more or less than the expected return. From an investment standpoint, an investor should choose securities that provide a higher return than the one predicted by CAPM.

Under the CAPM, the total risk of a stock/security consists of two components. These are diversifiable risks and non-diversifiable risks.

Diversifiable and non-diversifiable risk

Systematic or non-diversifiable risk:

Systematic risk is defined as risk caused by factors outside of a company’s control, such as market factors, GDP, inflation, interest rates, tax policy, government policy, and so on. These factors have an impact on all companies and cause variation in their returns. Systematic risk cannot be reduced by maintaining a well-diversified portfolio. As a result, systematic risk is that portion of total risk that cannot be eliminated through diversification. The beta coefficient (β) of a stock/security indicates its systematic risk and it reflects the sensitivity of a security’s return to market return.

Unsystematic or diversifiable risk:

It is the portion of total risk that can be diversified. It is created by variables like management, production or operational efficiency, labour conditions, and financial leverage, all of which are under a company’s control. Business risk and financial risk are two sources of unsystematic risk. Further, the securities that are not fully but less than ‘perfectly and positively correlated’ can be bundled to reduce unsystematic risk. It can be seen that unsystematic risk may be lowered to zero in an optimally diversified portfolio; thus, systematic risk is the only risk that matters in such a portfolio.

Capital Asset Pricing Model and its assumptions

According to CAPM, the expected return and systematic risk (measured by (β)) have a linear and positive relationship. The CAPM is a tool for estimating a security’s or a portfolio’s projected return. The model identifies how sensitive a security’s returns are to the return of the market portfolio. Some securities have a lower sensitivity, while others have a higher sensitivity. As a result, different securities and portfolios have varied characteristics. Furthermore, as previously noted, a security’s unsystematic risk can be diversified away, so an investor will not obtain a return or risk premium for taking on unsystematic risk. Only the systematic risk indicated by (β)will earn the investor a risk premium.

The capital asset pricing model is built on a set of explicit assumptions about the behaviour of investors. These assumptions are as follows:

• Risk-return estimations, evaluated in the terms of expected returns and standard deviations of returns, are used by all investors to make their investment decisions.
• An asset or security’s acquisition or sale can be done in infinitely divisible units.
• Prices are unaffected by a single seller’s purchases and sales. This suggests that complete competition exists, with investors determining prices based on their behaviour.
• There are neither any transaction costs nor are there any personal income taxes.
• The investor can lend or borrow any amount of money he or she wants at the same interest rate as that of riskless securities.
• Any amount of any shares can be sold short by the investor.
• Investors have a similar set of expectations.

The Capital Asset Pricing Model is stated by the following equation:

E(Ri) = Rf + (E(RM) – Rf) β

Here,

E(Ri) represents the expected rate of return from a particular stock/security.

Rf represents the risk-free return.

E(RM) shows the expected return on the market portfolio.

β stands for the beta factor of security.

Hence, as per Capital Asset Pricing Model,

Expected Return = Risk-Free Rate + Market Risk Premium × Systematic Risk.

The risk premium of a return can be computed as the product of Market Risk premium and Systematic risk of a security.

We can say that the expected return on a security is determined by the three factors listed below:

• The Risk-free rate of return: This is the time worth of money in its purest form. It is the reward an investor must receive solely for his or her time, with no risk assumed.
• The market price for risk or Market risk premium: This is the monetary compensation an investor must receive for taking on one unit of market or systematic risk.
• The Beta factor of security: This is the percentage of a security’s risk that is systematic. The projected return will be greater if the systematic risk is higher.

It should be highlighted that all securities will have the same risk-free rate of return and market risk premium. As a result, the beta factor or systematic risk is the only factor that generates differences in expected returns across diverse securities. The expected return from an investment will be higher if the systematic risk is higher.

Applicability of Capital Asset Pricing Model

The Capital Asset Pricing Model is used to figure out what a security’s expected or required rate of return is. CAPM is used in the wealth management sector to identify securities that are under-priced or overpriced, allowing a potential investor to buy in under-priced securities while an existing investor can sell overpriced securities.

Furthermore, we use the Weighted Average Cost of Capital^[1] (WACC) as the appropriate discount rate when making capital budgeting decisions in Financial Management. The cost of equity is an important component of WACC. The cost of equity, often known as the needed rate of return, is calculated using the Capital Asset Pricing Model.

The CAPM appeals to most people on an intellectual level since it is logical and rational. Despite the fact that its fundamental assumptions raise some worries in the eyes of investors, CAPM has been creatively adapted for its purpose by investment analysts.

By concentrating on market risk using the Capital Asset Pricing Model, investors are forced to consider the riskiness of assets in general. It presents the essential notions, which are of critical importance. It can be used to choose securities and portfolios. Higher-yielding securities are thought to be undervalued and hence attract buyers. Securities that are overvalued and have returns that are lower than the average should be sold.

Investors are thought to consider only market risk when using the CAPM. The expected return from a firm’s security can be calculated using an estimate of the risk-free rate, the firm’s beta, and the required market rate of return. This expected return could be utilized to calculate the cost of retained earnings.

In addition, historical data on the market return, risk-free rate of return, and beta factor vary for different time periods. The various methods adopted for figuring out these inputs have an impact on the beta value. Because the inputs cannot be precisely estimated, the expected rate of return determined by the CAPM model is also subject to criticism.

Limitations of CAPM

CAPM is a popular model for asset pricing and determining expected return, although it has been challenged for the following reasons:

• It is dependent on a number of implausible and unrealistic assumptions. Firstly, securities are not infinitely divisible in the real-life scenario; secondly, there are transaction fees and taxes involved, and also unlimited lending and borrowing at the same risk-free rate are not feasible.
• Moreover, the estimation of the (β) factor is a difficult issue. We can do a calculation of it based on past data. However, historical values may no longer be valid in the future. As a result, the (β) factor is not constant throughout time. Therefore, any error in (β) factor estimates will result in an erroneous estimate of the expected return.

Takeaway

The Capital Asset Pricing Model is a mathematical model that depicts the relationship between systematic risk and expected return for assets, specifically shares. CAPM is commonly used in finance to value risky securities and calculate projected returns for assets based on their risk and cost of capital. When a stock’s risk and time value of money are compared to its anticipated return, the CAPM method is used to determine if the stock is reasonably valued.

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