Capital Asset Pricing Model (CAPM): Assessing Investment Risk and Expected Returns

An in-depth exploration of the Capital Asset Pricing Model (CAPM), a framework used to analyze investment risk and predict expected returns. This entry covers its formula, assumptions, applications, and historical context.

Introduction to CAPM

The Capital Asset Pricing Model (CAPM) is a foundational financial theory that establishes a linear relationship between the expected return of an investment and its risk as measured by beta (β). It helps in assessing how much return on investment an investor should expect given the asset’s inherent risk compared to that of a risk-free asset.

CAPM Formula

The CAPM formula is expressed as:

$$ E(R_i) = R_f + \beta_i (E(R_m) - R_f) $$

where:

• \(E(R_i)\) = Expected return of investment
• \(R_f\) = Risk-free rate
• \(\beta_i\) = Beta of the investment
• \(E(R_m)\) = Expected return of the market portfolio

Assumptions Underlying CAPM

The CAPM operates under several key assumptions:

1. Investors are risk-averse and seek to maximize their utility.
2. Markets are frictionless, without transaction costs, taxes, or constraints on short selling.
3. All investors have access to the same information and interpret it uniformly.
4. Investors can borrow and lend at the risk-free rate.
5. The time horizon for all investments is the same.
6. Capital markets are in equilibrium.

Applications of CAPM

CAPM is widely used in finance for various purposes:

• Portfolio Management: Helping investors to decide on the optimal mix of assets.
• Performance Evaluation: Comparing portfolio returns to predicted returns.
• Investment Appraisal: Determining the appropriate discount rate for evaluating new projects or investments.
• Risk Management: Assessing and managing the risk exposure of investments.

Historical Development of CAPM

The development of CAPM can be traced back to the 1960s with key contributions from researchers:

• William Sharpe: Published “Capital Asset Prices” in 1964, introducing the CAPM.
• John Lintner: Independently developed similar models contemporaneously.
• Jan Mossin: Contributed to the model’s development in the same period. These foundational works have significantly influenced modern portfolio theory and financial economics.

Comparing CAPM with Other Financial Models

Arbitrage Pricing Theory (APT)

APT, developed by Stephen Ross, also seeks to explain asset returns but uses multiple factors rather than a single market factor. It allows for more flexibility but requires identifying and quantifying the influence of each factor.

Fama-French Three-Factor Model

The Fama-French model extends CAPM by introducing two additional factors: size risk (SMB - Small Minus Big) and value risk (HML - High Minus Low). It provides a more nuanced understanding of asset returns but at the cost of greater complexity.

FAQs

What Is Beta in the CAPM Model?

Beta (β) measures the sensitivity of an asset’s returns to the returns of the market portfolio. A beta greater than 1 indicates that the asset is more volatile than the market, while a beta less than 1 suggests less volatility.

Does CAPM Account for Diversifiable Risk?

No, CAPM only considers systematic risk, which cannot be diversified away. Unsystematic or idiosyncratic risk is assumed to be eliminated through diversification.

How Is the Risk-Free Rate Determined?

The risk-free rate is typically based on government securities, such as Treasury bills, which are assumed to have negligible default risk.

Summary

The Capital Asset Pricing Model (CAPM) is a critical tool in finance for evaluating investment risk and expected returns. Developed through the work of prominent economists like Sharpe, Lintner, and Mossin, CAPM continues to play a vital role in modern finance theory and practice. Despite its assumptions and limitations, it remains a benchmark for financial professionals and academics alike.

References

1. Sharpe, W. F. “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk.” Journal of Finance, 1964.
2. Lintner, J. “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics, 1965.
3. Ross, S. A. “The Arbitrage Theory of Capital Asset Pricing.” Journal of Economic Theory, 1976.
4. Fama, E. F., & French, K. R. “The Cross-Section of Expected Stock Returns.” Journal of Finance, 1992.

By understanding and applying CAPM, investors and financial analysts can make more informed decisions about asset pricing and risk management.