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The Capital Asset Pricing Model

The Capital Asset Pricing Model

No matter how much we diversify our investments, it's impossible to get rid of all the risk. As investors, we deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM) helps us to calculate investment risk and what return on investment we should expect.

The linear relationship between the return required on an investment (whether in stock market securities or in business operations) and its systematic risk is represented by the CAPM formula. 1. Systematic Risk - These are market risks that cannot be diversified away. Interest rates,

recessions and wars are examples of systematic risks. 2. Unsystematic Risk - Also known as "specific risk," this risk is specific to individual stocks and

can be diversified away as the investor increases the number of stocks in his or her portfolio. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves.

Modern portfolio theory shows that specific risk can be removed through diversification. The trouble is that diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares in the stock market can't eliminate that risk. Therefore, when calculating a deserved return, systematic risk is what plagues investors most. CAPM, therefore, evolved as a way to measure this systematic risk.

The Formula:
The CAPM is a model for pricing an individual security or portfolio . Sharpe found that the return on an individual stock, or a portfolio of stocks, should equal its cost of capital. The standard formula remains the CAPM, which describes the relations. The linear relationship between the return required on an investment and its systematic risk is represented by the CAPM formula:

The Capital Asset Pricing Model

CAPM's starting point is the risk-free rate . This equity market premium consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta."

According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's relative volatility - that is, it shows how much the price of a particular stock jumps up and down compared with how much the stock market as a whole jumps up and down. If a share price moves exactly in line with the market, then the stock's beta is 1.

CAPM Assumptions:
The assumptions of CAPM are as follows
All investors focus on a single holding period, and they seek to maximize the expected utility of their terminal wealth by choosing among alternative portfolios on the basis of each portfolio's expected return and standard deviation. All investors can borrow or lend an unlimited amount at a given risk-free rate of interest and there are no restrictions on short sales of any assets. All investors have identical estimated of the expected returns, variances, and covariance among all assets (that is, investors have homogeneous expectations). All assets are perfectly divisible and perfectly liquid (that is, marketable at the going price). There are no transaction costs. There are no taxes. All investors are price takers (that is, all investors assume that their own buying and selling activity will not affect stock prices). The quantities of all assets are given and fixed.

The Capital Asset Pricing Model

Security Market Line:

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The relationship between and required return is plotted on the securities market line (SML) which shows expected return as a function of . The securities market line can be regarded as representing a singlefactor model of the asset price, where Beta is exposure to changes in value of the Market. The equation of the SML is thus:

Asset Pricing:
Once the expected/required rate of return, , is calculated using CAPM, we can compare this required rate of return to the asset's estimated rate of return over a specific investment horizon to determine whether it would be an appropriate investment. To make this comparison, you need an independent estimate of the return outlook for the security based on either fundamental or technical analysis techniques, including P/E, M/B etc. Assuming that the CAPM is correct, an asset is correctly priced when its estimated price is the same as the present value of future cash flows of the asset, discounted at the rate suggested by CAPM. If the observed price is higher than the CAPM valuation, then the asset is undervalued (and overvalued when the estimated [2] price is below the CAPM valuation). When the asset does not lie on the SML, this could also suggest mispricing. Since the expected return of the asset at time is , a higher expected return than what CAPM suggests indicates that is too low (the asset is currently undervalued), assuming that at time the asset returns to the CAPM suggested price. The asset price using CAPM, sometimes called the certainty equivalent pricing formula, is a linear relationship given by


is the payoff of the asset or portfolio.

Risk & Diversification:

The risk of a portfolio comprises systematic risk, also known as undiversifiable risk, and unsystematic risk. Systematic risk refers to the risk common to all securities i.e. market risk. Unsystematic risk is the risk associated with individual assets. Unsystematic risk can be diversified away to smaller levels by including a greater number of assets in the portfolio .A rational investor should not take on any diversifiable risk, as only non-diversifiable risks are rewarded within the scope of this model. Therefore, the required return on an asset,

The Capital Asset Pricing Model

that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio contexti.e. its contribution to overall portfolio riskinessas opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability. In other words the beta of the portfolio is the defining factor in rewarding the systematic exposure taken by an investor.

The capital asset pricing model is by no means a perfect theory. But the spirit of CAPM is correct. It provides a usable measure of risk that helps investors determine what return they deserve for putting their money at risk.