Risks are an integral part of every investment. As the risks associated with an investment increase, investors expect to earn more returns as compensation for taking higher risks. The Capital Asset Pricing Model (CAPM) estimates the return on an investment based on the amount of risk the investment involves. In short, investors use CAPM to evaluate investments to make good investment decisions.
What Is CAPM Used for?
Primarily, the CAPM is used for the evaluation and assessment of the fair value of a stock. However, this is done by comparing the risks and monetary value of the stock per time to the expected return on investment.
Investors use the CAPM to assess stocks, determine their pricing, and ROI in the event of expected changes in risk factors. An example of such changes is an increase in interest rate.
Why Is CAPM Important?
There are several reasons why the CAPM is considered important for investors and in financial modeling at large. Such reasons include:
- With the CAPM, investors are able to estimate what an investment is most likely to return.
- With the knowledge of the expected ROI corresponding to a particular risk level, investors are able to determine the viability of an investment they are interested in.
- The CAPM can help investors assess the health and rebalancing of their investment portfolio.
- The CAPM puts systematic risks into consideration, assisting investors to make proper risk assessments for investments.
Systematic Risks
Some investment risks do not just affect a particular commodity or industry but influence the whole market. These kinds of risks are called systematic risks and are also known as market risks. In addition, systematic risks cannot be managed by diversification of investment. Examples include an increase in interest rates, recession, and more.
Unsystematic Risk
Unlike systematic risks, unsystematic risks are specific risks. These are risks associated with a particular stock or industry. As such, the effects of unsystematic risks are not felt on a market-wide scale.
These kinds of risks arise from the internal activities and moves of a particular industry or stock. But, they can be managed by diversification of investments. Examples include shortage of resources, mismanagement, employee strike, and more.
Portfolio Theory & CAPM
The Portfolio Theory seeks to analyze investment opportunities based on the correlation between the risks and the return on investment. Before the theory, it was easier to consider stocks one by one for assessment and evaluation. However, with the portfolio theory, investors can take the mean and standard deviation of the different assets in a portfolio.
On the contrary, CAPM does not just apply the portfolio theory, it extends it by being able to compare the return on investments to the entire market. In short, it brings in the idea of systematic and unsystematic risks. So, it can relate to both the expected return of the particular investment and that of the market at large.
Formula for CAPM
To calculate Capital Asset Pricing Model is, use the following formula:
ERi = Rf + Ɓ (ERm – Rf)
Where:
- ERi – Expected Return on Investment
- Rf – Risk-free rate
- Ɓ – Beta
- ERm – Expected Return on Market
- (ERm – Rf) – Market premium
Let’s consider each parameter in the formula and what they mean.
Expected Return
This is a representation of how the investment is expected to turn out with all other equation variables in place. The Expected Return is the expectation on the return on investment in the long run.
Risk-free Rate
This is expressed as an equivalent of the yield of a 10-year government bond in the United States. Moreover, it is important to note that the risk-free rate should be of the country’s government. Although the maturity period of the bond in other countries may differ, the professional is to use the 10-year rate.
Market Risk Premium
The market risk premium is simply the extra return beyond the risk-free rate. This serves as compensation to the investor for engaging a higher investment risk. In addition, the market premium increases with an increase in the volatility of an asset or market.
To calculate the market risk premium, subtract the risk-free rate from the expected market return.
Beta
The beta is a measure of a stock’s risk correlation with the market. It represents how sensitive an asset is to the market risks. For instance, a beta of 1.5 means that a company’s security is more susceptible to be affected by the market. However, a beta that is less than 1 is less risky since it isn’t affected by market volatility.
Example of CAPM
Let’s assume a U.S based stock that trades on NYSE. Suppose the excess return for U.S stocks is 8.5% on an annual basis. Take the current yield on a 10-year U.S stock to be 3.5%. With the CAPM formula, calculate the stock’s expected return if the stock has its beta at 1.5.
Listing out the parameters, we have:
- Risk-free rate = 2.5%
- Beta = 1.5
- Market premium = 8.5%
Expected return = 2.5% + (1.5 x 8.5%)
Expected return = 15.25%
Components of CAPM
These are important elements that constitute the CAPM model. They include:
Alpha
Alpha represents how an investment performs relative to an index that is set as a benchmark such as S&P 500. In simpler terms, alpha measures the excess return with which an investment beats the market or its benchmark index.
A positive alpha, say 1, indicates that an investment yields a return over the market average in a particular period. Contrarily, a negative alpha indicates that an investment performed below the overall market average.
Security Market Line
The Security Market Line, also referred to as the characteristic line, is a line on the graph of the CAPM against the entire market’s expected return. It is a graphical representation of the CAPM, with the risks plotted on the x-axis and the expected return plotted on the y-axis. In short, this line notifies investors whether stocks are over or undervalued.
Efficient Frontier
This refers to the portfolios that are estimated to yield the highest expected return on an investment given a specified risk level. It can also represent the set of portfolios whose risks are the lowest at a particular expected return. More importantly, portfolios of this nature are said to be optimal.
A portfolio is considered suboptimal if it is not up to the efficient frontier. Moreover, it’s either the portfolio returns a lower expected return for a defined risk level or the portfolio has a higher risk level for a particular expected return.
What Are CAPM Assumptions?
Some basic assumptions form the foundation of the CAPM. These assumptions include:
Investors Are Risk-Averse
The CAPM assumes that investors do not like risks and can employ strategies to avert them. Investors use the standard deviation or investment return and the expected ROI to assess their portfolio’s risk and return. In short, this assumption believes that all investors are rational in their investment decisions.
Investors Have Similar Expectations & Choices on Risk and Return
The CAPM assumes that all investors estimate risk and return in the same way. As a result, the expectation of every investor is clearly the same. Because of the similarity in the assessment and expectation of risks and return, the CAPM assumes that investors end up with similar rates.
Identical Time Horizon
The CAPM assumes that all investors operate an identical time horizon. This implies that the model assumes that all investors purchase their portfolio assets at a common time and sell them at a common point at a later time though undefined.
The contention over this particular assumption is that it is highly unrealistic as the time horizons and the stock value estimate of investors differ.
Available Information
This is the assumption that all investors can access all the available information for free. As such, the market is not considered efficient if there is any information that is accessible to only a set of investors and not all. In such cases, a common efficient frontier line will not be easy to achieve if there is a piece of information that not all investors have access to.
No Taxes or Transaction Costs
The CAPM assumes that transaction costs are mostly negligible and taxes are inconsequential to investors’ choice of investments.
No Restriction on Borrowing at Risk-Free Rate
This is an assumption that investors can borrow at risk-free rates without any form of limitations. It is also assumed in CAPM that there are risk-free assets an investor can add to his portfolio. However, this isn’t always the case.
Assets Are Divisible & Marketable
This assumption supports the view that all assets are divisible, and this makes allowance for the CAPM to employ continuous functions.
Advantages of CAPM
The CAPM has many advantages that have kept the model as the preferred choice above some other financial model. One of such advantages is that it is easy to use and still gives a good estimate of the expected return of an investment. Other advantages include:
Diversified Portfolio
By assuming that investors hold a diversified portfolio, the CAPM eliminates unsystematic risk. Instead, it takes systematic risks into account, unlike other models. In short, this is an advantage because systematic risks are an important variable that is unforeseen. Including it in the model raises the expectation of the systematic risks.
Risk Variability
In a case where the business mix and risks of a business vary, other methods of calculating returns such as the Weighted Average Cost of Capital (WACC) may not work. In such cases, the CAPM can still apply.
Criticisms of CAPM
Despite its ability to give a good estimate of the expected return on investment, the CAPM has some drawbacks. Some of them include:
The Short Term Risk-free Rate
The risk-free rate used for the CAPM calculations is on short-term government securities. Meaning, the value may be inconsistent, varying from day to day, thereby generating volatility.
The Return on the Market
Estimations and expectations may not always go as planned. As such, it is possible for the return on the market to go negative. Therefore, this occurrence distorts the whole CAPM calculations.
Ability to Borrow at a Risk-free Rate
It is unrealistic to assume that investors can lend and borrow at a risk-free rate. In the U.S, investors who are individuals may not be able to lend or borrow at the same rate as the government.
Difficulties With Beta
It is often not easy to accurately determine the beta of a good investment since there are many different ways to calculate it. In short, this may introduce errors to the model and may compromise the reliability of the output.
What to Keep in Mind When Using CAPM
The CAPM works with many assumptions that may not hold for all cases or may be unrealistic. It is also important to note that the CAPM does not fully account for the volatility of the stock market.
Additionally, keep in mind that the volatility of the stock market may influence some changes in the prices or interest rates. The implication is that risks and returns may not eventually even out.
Bottom Line
Evaluating and assessing investment risks is a very crucial part of managing investments. Additionally, you need to ascertain that the expected return on investment is worth the risk you take. Therefore, you can contact a good financial advisor to assist you in your risk and return assessment and also provide professional advice.