Explain the Capital Asset Pricing Model (CAPM)

The CAPM was conceived in the early 1960s by William Sharpe, John
Lintner, and Jan Mossin He took up the question of how risk—more
specifically (systematic risk), risk that could not be diversified away—
influenced returns. His research led to the capital asset pricing model,
which he introduced in his 1970 book, “Portfolio Theory and Capital
Markets.”
Sharpe was looking at diversification, more specifically which risks can
be dealt with by diversification and which cannot. In the CAPM
framework, he identified two types of risk:

 Systemic Risk. Also called market risk, this is general risk from
developments impacting the entire economy and all investment assets. It
is influenced by factors such as interest rates, inflation, recessions and
geopolitical events like war. Systemic risk applies to the market as a
whole, which means that all assets are impacted in similar ways.
 Unsystemic Risk. Also known as specific risk, these are risks that are
unique to each asset. Individual stocks face risks from adverse
developments at companies that may not impact any other peer firms, for
instance. These risks are not correlated across different assets, unlike
systemic risk.
Specific risk can be reduced by diversification, or investing in a basket of
different assets—a concept that’s at the heart of modern portfolio
theory (MPT). But systemic risk is a tougher nut to crack since it impacts
all investment assets in a similar way.
The capital asset pricing model concentrates on measuring
systemic risk and its impact on the value of an asset. CAPM helps
factor in systemic risks to estimate the fair value of an asset and
understand the relationship between risk and expected returns.
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Derivation of Sharpe Ratio

Starting with Markowitz;

R p =w1 R1 +w 2 R2 (1)
2 2 2 2 2
σ p=w 1 σ 1+ w2 σ 2 +2 w 1 w 2 σ 1 σ 1 γ 12 (2)
In the above equation, we will just add one line that one security is risky
and the other one is risk free.
R1=R f R2=R m
σ 1=0 ( Risk Free ) σ 2=σ m
Now putting the values in equation “1”
R p =w1 Rf + w2 Rm
2 2 2 2
σ p=w 1 ( 0 )+ w2 σ m +2 w 1 w2 ( 0 ) σ m γ fm
2 2 2
σ p=w 2 σ m
After simplification, we have
σp
w 2=
σm
We also know that w 1=1−w2
So, we can write equation “1” as follow;
R p =(1−w2 ) R1 + w2 R 2
Here it doesn’t matter whether you replace w 1∨w 2 because at the end you
will get same equation.
R p =R 1−w 2 R1 + w2 R 2
R p =R 1+ w2 ( R 2−R1)
Now placing the all the values in the above equation, we have.
σp
R p =R f + ( Rm −Rf )
σm
Here the ( Rm −Rf ) is the excess return. So, Sharpe actually tells us excess
returns per unit of risk. The above equation is called CML (Capital
Market Line). Capital Allocation Line is also used for the above equation.
Summarizing the above equation, if you add risk free securities to the
risky securities, you can identify a relationship between a portfolio risk
and portfolio return. Markowitz describes that how risk of portfolio is
calculated but haven’t discussed about the risk-return relationship.
Sharpe established the relationship between portfolio risk and return i.e.
if portfolio risk (σ p) is increased then the portfolio returns is also
σp
increased proportionately. The coefficient is called Sharpe ‘Ratio’. It
σm
means that if there is one unit change in portfolio risk then in returns the
Sharpe ratio times change will occur. If a portfolio creates high Sharpe
Ratio the effect of per unit of risk on return of the portfolio would be
high. So, if want to compare securities then we can decide on the basis
of Sharpe Ratio. Higher the Sharpe Ratio indicates better performance of
the securities.
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Understanding the Capital Asset Pricing Model (CAPM)

The formula for calculating the expected return of an asset, given

its risk, is as follows:
ERi = Rf + βi (ERm − Rf)
where:
ERi = expected return of investment
Rf = risk-free rate
βi = beta of the investment
(ERm − Rf) = market risk premium

1. Expected Rate of Return on Investment (ERi)

An asset or investment’s expected rate of return is how much the

investor should make over the investment’s lifetime. In the CAPM
formula, the expected rate of return is based on the other factors within
the equation, like the stock’s beta and the return rate of the market.

2. Risk-Free Rate of Return (Rf )

In theory, certain securities (stocks or bonds) have no risks. In the U.S.,

the risk-free rate of return is usually based on the return rate for a three-
month treasury bill or 10-year government bonds. Using securities
issued by the government is the baseline for risk-free rates because the
U.S. government is unlikely to default on payment. No default in
payments means these investments pose minimal risk to investors.

3. Beta (β)

In corporate finance, beta (β) measures the systematic risk of a security

compared to the broader market (i.e. non-diversifiable risk). The beta is a
numerical representation of how volatile the stock’s price is compared to
the market. Beta can also be thought of as the stock’s sensitivity to
market changes — a sensitive stock will be very volatile (have a high
beta), while a more steadfast stock will not react to market changes as
much (have a low beta).
The relationship between beta (β) and the expected market sensitivity is
as follows:
 β = 0: No Market Sensitivity
 β < 1: Low Market Sensitivity
 β = 1: Same as Market (Neutral)
 β > 1: High Market Sensitivity
 β < 0: Negative Market Sensitivity
For instance, a company with a beta of 1.0 would expect to see returns
consistent with the overall stock market returns. So if the market has
gone up by 10%, the company should also see a return of 10%.
But if that company were to have a beta of 2.0, it would expect a return
of 20% assuming the market had gone up by 10%.

4. Risk Premium (ERm − Rf)

In the capital asset pricing model, the risk premium (also called the
market risk premium) is the difference between the risk-free rate of
return and the returns on a specific stock or investment. Essentially, this
is how much the investor is rewarded for taking a risk rather than
investing in lower- or zero-risk options, like government bonds. If a
stock, asset, or investment is very risky, it will have a high risk premium,
meaning the investor should see a higher reward for their risk.

CAPM Calculation Example

Using the capital asset pricing model formula, we can calculate the
expected rate of return on a stock.
Suppose we have three companies that each share the following
assumptions:
 Risk-Free Rate (rf) = 2.5%
 Expected Market Return = 8.0%
Since we’re given the expected return on the market and risk-free rate,
we can calculate the equity risk premium (ERP) for each of the three
companies using the formula below:
 Equity-Risk Premium (ERP) = 8.0% – 2.5% = 5.5%

ERi = Rf + βi (ERm − Rf)

ERi = 2.5% + βi (8.0% -2.5%)
 ERi = 2.5% + βi (5.5%)
The difference in expected returns among the three companies will be
attributable to the beta (i.e. systematic risk).
 Beta (β), Company A = 0.5
 Beta (β), Company B = 1.0
 Beta (β), Company C = 1.5
To calculate the expected return on investment (ERi) we’ll take the risk-
free rate and add it to the product of beta and the equity risk premium,
with the ERP calculated as the expected market return minus the risk-
free rate.
For example, Company A’s cost of equity can be calculated using the
following equation:
 expected return on investment (ERi) = 2.5% + (0.5 × 5.5%) =
5.3%
Under the provided assumptions, the expected equity returns for the
three companies come out to 5.3%, 8.0%, and 10.8%, respectively.
 Expected return on investment (ERi), Company A = 5.3%
 Expected return on investment (ERi), Company B = 8.0%
 Expected return on investment (ERi), Company C = 10.8%

The CAPM and the Efficient Frontier

Using the CAPM to build a portfolio is supposed to help an investor
manage their risk. If an investor were able to use the CAPM to perfectly
optimize a portfolio’s return relative to risk, it would exist on a curve
called the efficient frontier, as shown in the following graph.
The graph shows how greater expected returns (y-axis) require greater
expected risk (x-axis). Any portfolio that fits on the capital market line
(CML) is better than any possible portfolio to the right of that line, but at
some point, a theoretical portfolio can be constructed on the CML with
the best return for the amount of risk being taken.

The CML and the efficient frontier may be difficult to define, but they
illustrate an important concept for investors: There is a tradeoff between
increased return and increased risk. Because it isn’t possible to perfectly
build a portfolio that fits on the CML, it is more common for investors to
take on too much risk as they seek additional return.

CAPM and the Security Market Line (SML)

The efficient frontier assumes the Return

C
same things as the CAPM and SML
0.30
can only be calculated in theory. Market
0.25
If a portfolio existed on the
efficient frontier, it would provide 0.20

maximal return for its level of 0.15

risk. However, it is impossible to B
0.10 A

Rf=0.05
0.5 1.0 1.5 Risk (Beta)
know whether a portfolio exists on the efficient frontier because future
returns cannot be predicted.
This tradeoff between risk and return applies to the CAPM, and the
efficient frontier graph can be rearranged to illustrate the tradeoff for
individual assets. In the following chart, you can see that the CML is now
called the security market line (SML). Instead of expected risk on the x-
axis, the stock’s beta is used. As you can see in the illustration, as beta
increases from 1 to 1.5, the expected return is also rising.
A higher beta means more risk, but a portfolio of high-beta stocks could
exist somewhere on the CML where the tradeoff is acceptable, if not the
theoretical ideal.

What Are Some of the Assumptions Built In to the CAPM Model?

The following are assumptions made by the CAPM model:

 All investors are risk-averse by nature.

 Investors have the same time period to evaluate information.
 There is unlimited capital to borrow at the risk-free rate of return.
 Investments can be divided into unlimited pieces and sizes.
 There are no taxes, inflation, or transaction costs.
 Risk and return are linearly related
Many of these assumptions have been challenged as being unrealistic or
plain wrong.

What Are Some Alternatives to the CAPM?

Because of its criticisms, several alternative models to the capital asset

pricing model have been developed to understand the relationship
between risk and reward in investments.

One of these is arbitrage pricing theory (APT), a multi-factor model that

looks at multiple factors, grouped into macroeconomic or company-
specific factors.
Another is the Fama-French 3-factor model, which expands on CAPM by
adding company-size risk and value risk factors to the market risk
factors.