Capital Asset Pricing Model (CAPM)¶
The Capital Asset Pricing Model (CAPM) is a foundational finance theory that describes the relationship between systematic risk and expected return for assets, particularly stocks. Developed in the 1960s by Jack Treynor, William Sharpe, John Lintner, and Jan Mossin independently, CAPM is widely used to estimate the cost of equity and as a method for calculating expected investment risks and returns.
Overview¶
CAPM is based on the premise that investors need to be compensated in two ways: time value of money and risk. The model provides a methodology to quantify risk and translate it into estimates of expected return on equity.
Formula¶
The CAPM formula is expressed as:
\(E(R_i) = R_f + \beta_i (E(R_m) - R_f)\)
Where: - \(E(R_i)\) is the expected return of the investment, - \(R_f\) is the risk-free rate, - \(E(R_m)\) is the expected return of the market, - \(R_f\) is the risk-free rate, - \(beta_i\) is the beta of the investment, - \((E(R_m) - R_f)\) is known as the market risk premium.
Components Explained¶
- Risk-Free Rate \((R_f)\): This is the return of a risk-free asset, typically a Treasury Bill.
- Beta \((beta_i)\): It measures the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
- Market Risk Premium \((E(R_m) - R_f)\): This is the additional return over the risk-free rate that investors require to be compensated for the risk of holding a risky asset.
Applications of CAPM¶
- Determining the Cost of Equity: CAPM is used to calculate the cost of equity, which helps in evaluating whether a security is fairly valued based on its risk.
- Portfolio Management: Investors can use CAPM to assess the performance of a portfolio by comparing expected returns to actual returns.
- Capital Budgeting: Firms use CAPM to estimate the return of an asset-related investment, which can guide decisions on whether or not to proceed with a project.
Assumptions¶
CAPM assumes that: - Investors are risk-averse, rational, and seek to maximize utility. - Markets are perfectly competitive, efficient, and securities are infinitely divisible. - There are no taxes, transaction costs, or restrictions on short selling. - All investors have the same information and they can lend and borrow unlimitedly at the risk-free rate. - Investments are held in a single-period time frame.
Limitations¶
- Market Efficiency: CAPM assumes all information is freely available to all market participants, which is not always the case.
- Single-Factor Model: It only considers market risk and ignores other types of risks such as liquidity or operational risks.
- Historical Beta: Beta is calculated based on historical data, and may not be a reliable indicator of future risk.
- Assumptions About Risk: Not all investors have the same risk aversion, and real markets have taxes and transaction costs.
Conclusion¶
Despite its limitations, CAPM remains a powerful tool in financial management for estimating expected returns on securities when considering the risk involved relative to the broader market. Understanding CAPM helps investors and financial managers make more informed decisions about which investments align with their risk tolerance and expected return thresholds.
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