13-Nov-2023
2 mins read
Introduction
In modern finance, it’s important to grasp the Capital Asset Pricing Model (CAPM) as an aid in making informed decisions while investing in the financial markets. Such investments have pitfalls and uncertainties at every turn. A collection of financial models and tools have been created to scrutinise the associated risks and predicted rewards of the investments. In this extensive blog, we will delve deeply into the CAPM, exploring its formula, understanding systematic and unsystematic risks, the crucial role of beta, assessing its advantages for investors, and shedding light on its limitations.
Formula for CAPM
The Capital Asset Pricing Model (CAPM) is a financial framework used to quantify the relationship between the expected return on an investment and its level of systematic risk. The formula for CAPM can be expressed as:
Ra = Rf + βe (Rm−Rf)
Breaking down the elements of the formula:
- Ra: This represents the expected return on the investment.
- Rf: It denotes the risk-free rate, a foundational concept often associated with government bonds or similar low-risk instruments.
- βe: Beta, an essential parameter, represents the risk of the investment in relation to the current market conditions.
- (Rm−Rf): This component signifies the current market risk premium, the excess return expected from the market compared to the risk-free rate.
Essentially, this formula calculates the expected returns an investor can anticipate based on their risk tolerance and the risk characteristics of the investment, as captured by beta.
Assessing Systematic and Unsystematic Risks
In the context of CAPM, it is essential to have a clear understanding of systematic and unsystematic risks.
- Systematic Risks: These are general risks that are associated with any form of investment. They are factors that impact the entire market. Examples of systematic risks include wars, changes in inflation rates, recessions, political events, and monetary policy shifts. These risks are beyond the control of individual investors and can affect the value of investments on a broad scale.
- Unsystematic Risks: In contrast, unsystematic risks are specific perils associated with investing in a particular stock or equity. These risks are not shared by the overall market and are often related to factors unique to the company or industry. Examples of unsystematic risks include company-specific events like management changes, product recalls, or legal disputes.
CAPM primarily deals with systematic risks in securities, aiming to predict potential issues associated with particular investments. The goal is to determine if the systematic risks outweigh the expected returns from the investment.
The Underlying Assumptions of the CAPM
- Uniform Objective for Maximising Economic Utility: The first assumption of CAPM posits that all investors share the common goal of maximising their economic well-being. This assumption is made while considering that the quantity of assets held by investors remains constant and predetermined.
- Rationality and Risk Aversion: The second assumption stipulates that investors are rational decision-makers who are inherently risk-averse. This means that they make choices that maximise expected utility while minimising exposure to risk.
- Broad Diversification: The third assumption of CAPM asserts that investors maintain a broad and diversified portfolio encompassing various investments. Diversification is considered a key strategy for risk management in this context.
- Price-Taking Behavior: The fourth assumption states that investors are price-takers, implying that they operate in markets where they do not influence asset prices. In other words, they accept the prevailing market prices as given.
- Unlimited Borrowing and Lending under Risk-Free Rate: The fifth assumption highlights that investors have the ability to lend and borrow funds without constraints and at a risk-free rate of interest. This assumption simplifies the model by allowing for risk-free borrowing and lending.
- Zero Transaction and Taxation Costs: The sixth assumption is that investors can engage in transactions without incurring any costs, and there are no taxes imposed on their investment activities.
- High Divisibility and Liquidity of Assets: The seventh assumption posits that all securities are perfectly divisible into small units and are highly liquid. This ensures that investors can easily buy and sell assets without facing liquidity constraints.
- Homogeneous Expectations: The eighth assumption assumes that all investors hold homogeneous expectations about future asset returns and risks. This simplification is made to facilitate the modelling process.
- Simultaneous and Equal Access to Information: The ninth and final assumption of CAPM suggests that all investors have equal access to information, and they receive this information simultaneously. In other words, there are no information asymmetries or advantages among investors.
These assumptions serve as the foundational building blocks of the CAPM model. Though they help in creating a useful model, it is essential to recognise that in real-world financial markets, they may not always hold true to the same degree.
Example of CAPM
Let’s walk through the following examples to better understand how the CAPM formula works.
- An investor is considering purchasing shares of XYZ Limited, priced at Rs 367 per share, with an annual return of 4%. The beta associated with these shares is 1.1. Assuming a risk-free rate of 3% and an expected market appreciation of 7% annually. Applying the CAPM formula to calculate the expected return (Ra):
Ra = 3 + 1.1*(7-3) = 7.4%
Therefore, based on the CAPM model, the expected return for investing in XYZ Limited is 7.4%.
- An investor is contemplating purchasing shares of ABC Limited worth Rs 455 with an expected annual return of 9%. The beta for these shares is 0.8. The risk-free rate is 5%, and the investor expects the market to appreciate by 8% within the next year.
Applying the CAPM formula:Ra = 5 + 0.8(9-5) = 8.2%
In this scenario, the expected return on the investment in ABC Limited is 8.2%.
These examples illustrate how the CAPM formula can be applied to different investment scenarios, providing an estimate of expected returns based on systematic risk and market conditions.
The Role of Beta in CAPM
Beta (β) plays a pivotal role in the CAPM model, as it measures the volatility of an investment relative to the broader market. Beta indicates how an asset’s returns correlate with market movements, offering insights into its stability or volatility.
| Situation | Meaning | Implications | |
| β=1 | The asset’s price moves in sync with the market. | If the market rises by ‘x’ percentage, the asset’s price also grows by ‘x’ percentage, and when the market falls, the asset’s price declines accordingly. | |
| β>1 | The asset is more volatile than the market. | The asset’s price is expected to increase by more than 5%, when the market increases by 5% and vice versa, if the market drops, the asset’s price is likely to fall more than the market. | |
| β<1 | The asset is less volatile than the market. | When the market rises, the asset’s price will go up by a smaller % and go down by a smaller % when the market falls. |
In essence, beta provides a relative measure of risk associated with an investment. It helps investors understand how the asset’s performance is likely to be influenced by market movements.
How Does CAPM Benefit Investors?
CAPM offers several advantages to investors, making it a valuable tool in the world of finance:
- Diversification Assumption: CAPM assumes that investors maintain diversified portfolios. Diversification involves spreading investments across different asset classes to reduce unsystematic risks. By holding a diversified portfolio, investors can mitigate the impact of company-specific events or industry-related risks.
- Simplicity and Convenience: CAPM is a user-friendly model known for its simplicity. The results using CAPM are easily accessible and easy to interpret for both beginners and experienced investors.
- Consideration of Systematic Risks: CAPM incorporates systematic risks into its calculations. Systematic risks, being beyond an individual investor’s control, are essential to consider when evaluating investments. By accounting for these risks, CAPM provides a realistic view of the potential returns from an investment.
- Benchmark for Expected Returns: CAPM provides a benchmark for investors to compare expected returns from different assets. This benchmark assists in the creation of diversified portfolios tailored to individual risk preferences. It helps investors make informed decisions about the risk-return trade-off in their portfolios.
- Market Expectations: CAPM provides a real-world perspective on whether a particular investment opportunity is attractive relative to broader market conditions. This is because it considers the risk-free rate and the expected market return. This information allows investors to align their investment choices with their financial goals and risk tolerance.
Drawbacks of CAPM
While CAPM is a widely used model in finance, it is not without its limitations:
- Changing Risk-Free Rates: CAPM relies on a constant risk-free rate, which can be a drawback. The risk-free rate is typically based on short-term government securities, and its value can change frequently. This volatility can impact the accuracy of CAPM calculations.
- Realism of Risk-Free Rate: The assumption that all investors can lend and borrow at the same risk-free rate as government securities may not hold true in practice.
Conclusion
CAPM remains a vital tool for investors, offering a structured approach to assessing expected returns while considering systematic risks. Though it has its drawbacks, it provides a valuable overview of the potential returns an investor can expect while taking on specific levels of risk.