What Is The Capm

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02 Nov 2017

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There are many tools out there that help in identifying the best possible investment scenario for an investor. The diverse investment avenues commonly available to an investor include stocks, government bonds, corporate bonds, options, real estate, commodities, mutual funds, and is not limited to these only. It becomes a question of what fits the risk profile of the investor and also coincides with the investor’s preferred asset class. The investment decision might also vary depending on the time horizon for which an investment is being done and this criterion is often taken into account when choosing the right asset class for investment purposes. The most widely used means of investment is the common stock of the companies trading on the secondary stock market. A stock is a type of investment that gives the investor partial ownership of a publicly traded company. (Fargo, 2013) For instance, the share of Google, Apple or General Electric that trade on the NYSE are all potential choices for an investor who is looking for an avenue that gives him the best possible return for his investment. We are all aware that since we have limited funds to invest from and owing to the concept of scarce resources, we have to carefully evaluate each and every individual stock that fits into our risk profile. The most established method to analyze a stock for its suitability in the investment portfolio is known as the Capital Asset Pricing Model (or CAPM).

The Capital Asset Pricing Model clearly states that the expected risk premium on each investment is proportional to its specific beta. This can be interpreted as saying that every investment should potentially lie on the sloping Security Market Line that connects the Treasury bill with the market portfolio. (Brealey, et al., 2011) CAPM is generally used for the pricing of securities that carry risk unlike the traditional Treasury bills or risk-free assets that have a zero beta. The model drives a simple relationship between each individual stock’s risk and its expected return, and helps the investor realize if the security is a good or a bad investment. (Anon., 2013) The formula for CAPM is: Ri = Rf + Bi ( RM – Rf), where, Ri stands for expected return on the stock, Rf stands for Risk-free rate or the prevailing rate on risk-free asset, Bi stands for Beta of the stock with the market, and finally RM stands for the Expected market return. (University, 2013)

Assumptions:

The Capital Asset Pricing Model is not a perfect model as it based on several assumptions that have been taken into account to simplify its application. For instance, it is assumed that U.S. Treasury bills are a complete risk-free investment, whereas in the real world there is no guarantee that they will generate a real return. There is a chance of default, and the effect of inflation is uncertain to a certain extent, which makes the U.S. Treasury bills prone to small level of risk, which has been ignored in this simplified model.

Another significant assumption that the model rests on is that the investors can easily and readily ‘borrow money at the same rate of interest at which they can lend.’ (Brealey, et al., 2011) It has generally been observed in the market that realistic borrowing rates are slightly higher than the prevailing lending rates for the same amount of funds.

Also, according to CAPM, all investors are rational and risk-averse who eventually ‘seek to maximize the expected utility of their portfolio over a single period planning horizon.’ (Chandra, 2008) Moreover, it is assumed that the market in which securities are trading have no transaction cost, there are no taxes, securities are essentially divisible, and all this makes the market competitive. This assumption directly relates with the characteristic of the capital market.

Finally, investors have homogenous expectations about the market risk and return, which in other words can also be described as having the same belief about the means, variances and covariance’s of the securities. (Fabozzi & Markowitz, 2011) The existence of this belief often gives a fair ground to every investor when he analyses any security based on the level of information that is available to him or her. Most of these assumptions are based on the premise of how investors make decisions.

The simplifying assumptions that have been used in the CAPM make investor’s life relatively easier in deducing properties of the market equilibrium. Although it is quite possible to include one assumption at a time to see its effect on the outcome of the model, but without these complexities even basic level investors can make use of the CAPM.

CAPM – Explained

Image 1: Brealey, R., Myers, S. & Allen, F., 2011. Principles of Corporate Finance. 10th ed. New York: McGraw-Hill Irwin

The general idea behind CAPM’s formation is that investors should be compensated for two factors, namely the time value of money and risk undertaken. The first they achieve by being paid an amount which is equal to the risk free-rate prevailing in the market. The second is obtained by measuring the stock’s Beta with the market. Beta represents the riskiness of the asset compared with the market, so an asset that has a Beta of 1, will move by the same amount when the market goes up. While, an asset having a Beta of more than 1 is said to be aggressive, because if the market goes up by 1%, the asset price will go up by more than that and vice versa. Lastly, as asset with a Beta of less than 1, is said to be defensive, since its reaction to the market movements is passive. Beta helps in establishing how much extra risk the investor has undertaken besides the market risk that generally exists. The Market Risk Premium is the difference between the Expected Market Return and the Risk free Rate. The multiplication of the stock’s Beta with the Market Risk Premium gives us the expected return above the risk free rate that the investor should be entitled to for his investment in the risky asset.

When we delve deeper into the analysis of the stock risk, we characterize risk as either being associated with the market or with the individual company to which the stock belongs to; these are termed as Systematic and Idiosyncratic Risk respectively. As mentioned above, the market should provide a return to the investor that is indicative of the risk that prevails because of the market, and that is exactly why we multiply Beta (stocks riskiness) with the Market Risk Premium, assuming Beta for the Market is 1.

Example: Ri = Rf + Bi (RM – Rf)

Risk-free rate: 5%

Beta (stock 1) = 1.8

Beta (stock 2) = 0.85

Beta (stock 3) = 1

Expected Market Return = 8%

Expected Return (S1) = 5 + 1.8 * (8-5) = 10.4%

Expected Return (S2) = 5 + 0.85 * (8-5) = 7.55%

Expected Return (S3) = 5 + 1 *(8-5) = 8%

Hence, a stock with a Beta of ‘1’, has the same Expected Return as the market and is considered to lie on the security market line.

The Security Market Line (SML) is a graphical representation of the CAPM,

E(Ri )= Rf + [(E(Ri ) – Rf)/var(RM)]*cov(Ri ,RM) (Fabozzi & Drake, 2009)

In a state of equilibrium, the expected return of the stock lies on the SML. In a situation where the expected return of a stock calculated through the CAPM lies below the SML, it shows the stock is ‘underpriced’ and should be invested in. On the other hand, if a stock’s expected return lies above the SML, it gives an indication that the stock is ‘overpriced’ and should be sold or not considered as one of the investment options. This is a very important application of the CAPM as it helps in identifying the outperforming or the underperforming stocks and gives an idea of what is to be expected from the stock in the future. The existence of theories like ‘mean reversion’ combined with this, help the investor make real-time investment decisions based on a short analysis. (C., 2007) This saves time and simplifies the many intricacies that exist in the investment decision making process.

CAPM has potential drawbacks because of its underlying assumptions. Among them the most significant is ‘the single period time horizon of the model’. Also noteworthy is the fact that the model relies on historically based data, whereas ideally it should be the forward-looking data that will give a better prediction of the stock’s future performance and truly reflect the investment required. Many experts in this field have opted to use other measures to evaluate the stock’s expected return such as the Consumption CAPM, which is a slight variation of the original model. In CCAPM the equations that describe the behavior of the asset prices and returns are derived from the consumption/saving and asset choice decisions of households. (Anon., 2013) Moreover, the CCAPM highlights that the ultimate reason to accumulate wealth is to simply fund the consumption of the household. (Baker & Nofsinger, 2010)There is in-depth discussion about the extent to which the varied versions of the CAPM are reliable, but the bottom line is that CAPM gives an investor a quick way to analyze his investment decision.



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