Capital Assets Pricing Model (CAPM)

Meaning Of Capital Assets Pricing Model (CAPM)

CAPM stands for capital asset pricing model, and it is a special model used in finance to determine the relationship between expected dividends and the risk of investing in a specific equity. When determining the expected returns for a security, the CAPM model is employed. A comparison can be made between this and the risk-free returns plus the addition of a beta factor.

It is necessary to understand both systematic and unsystematic risk in order to properly evaluate the capital asset pricing model. Systematic risks are any and all of the general dangers that are associated with any type of investment. The possibility of various risks, such as inflation, war, and recession, should not be underestimated. Just a few examples of systematic risk are provided here.

Unsystematic risks, on the other hand, are the risks associated with investing in a specific stock or equity that are not related to the overall market. In contrast, unsystematic risks are not regarded as threats and are, in most cases, accepted by the market as such.

The CAPM focuses on systematic risks in securities and, as a result, can predict whether or not a particular investment will succeed.

CAPM Formula

Expected Return (Ke) = rf + β (rm – rf)

Where:

Ke → Expected Return on Investment

rf → Risk-Free Rate

β → Beta

(rm – rf) → Equity Risk Premium (ERP)

Breakdown of CAPM Formula

Risk-Free Rate (rf): The risk-free rate should theoretically reflect the yield to maturity of default-free government bonds with maturities that are equal to the duration of each cash flow being discounted to begin with, but this is not always the case.

Nevertheless, due to a lack of liquidity in government bonds with the longest maturities (as evidenced by lower trade volumes and data sets), the current yield on 10-year US treasury notes has emerged as the de facto proxy for the risk-free rate assumption for companies based in the United States.

Beta (β): When comparing a security to the broader market, beta is used to measure the systematic risk of the security (i.e. non-diversifiable risk). The beta of an asset is calculated by dividing the covariance between expected returns on the asset and the market by the variance of expected returns on the market, which is the expected return on the asset.

Beta/Market Sensitivity Relationship

β = 0: No Market Sensitivity

β < 1: Low Market Sensitivity

β = 1: Same as Market (Neutral)

β > 1: High Market Sensitivity

β < 0: Negative Market Sensitivity

There is Two Type Of Risk In Beta

Systematic Risk:

• Systematic risk is a type of risk that affects the whole stock market, not just a single company or industry. It is not specific to a single company or industry.

• There is no way to avoid systematic risk, and diversifying your portfolio can't help (e.g. global recessions)

Unsystematic Risk:

• Risk that is specific to one company or one industry can be reduced by diversifying one's portfolio (e.g. supply chain shutdowns, lawsuits)

• Diversification is better when the portfolio has investments in different types of assets, industries, and countries.

Equity Risk Premium (ERP)

Our third input, the equity risk premium, measures the incremental risk (or excess return) associated with investing in equities as opposed to risk-free investments.

Considering that investing in risky assets such as stocks involves additional risk (i.e. the potential for capital loss), an equity risk premium is offered to investors as a means of providing them with an additional incentive to take on the risk of owning stocks.

Pros And Cons Of CAPM

Pros

Assumption that your portfolio is diverse: This model makes the assumption that an investor has a diverse investment portfolio that can reduce specific or unsystematic risk.

Easy to use and convenient: The model's ease of use and convenience serve as its foundation. These calculations are accurate, and they enable investors to make well-informed decisions when selecting stocks.

Systemic risks have the potential to significantly alter this calculation: A factor known as the beta factor in capital asset pricing models takes into account all of the systematic risks associated with a particular investment. The dividend discount model (also known as the DDM), which is another popular return prediction model, does not take into account the effects of these risks on returns. Because market risk is unpredictable and unpredictable, investors are unable to completely eliminate it.

Cons:

Rates that are considered risk-free are more likely to fluctuate frequently: The short-term government securities that generate the risk-free premium, or rate, that is used in CAPM calculations are the source of the rate. This model has a significant flaw: the risk-free rate can fluctuate dramatically in a matter of days.

Determining a beta can be difficult: for example, This model of return calculation necessitates investors calculating a beta value that accurately reflects the security in which they are investing. Calculating an accurate beta value can be a difficult and time-consuming task. In the vast majority of cases, a proxy value for beta is employed. This not only speeds up the calculation of returns, but it also reduces the accuracy of those calculations. Comparing a capital asset pricing model to other scientific models, it exhibits similar flaws and shortcomings. However, it still provides an accurate picture of the types of dividends that investors can expect to receive if they are willing to put their funds at risk.