Capital Asset Pricing Model

Although at first glance it looks likes a simple formula, the capital asset pricing model (CAPM) represents
an historic effort to understand and quantify something thats not at all simple: risk. Conceived by Nobel
economist William Sharpe in 1964, CAPM has been praised, appraised, and assailed by economists ever
since.

What It Measures
The relationship between the risk and expected return of a security or stock portfolio.

Why It Is Important
The capital asset pricing models importance is twofold.
First, it serves as a model for pricing the risk in all securities, and thus helps investors evaluate and measure
portfolio risk and the returns they can anticipate for taking such risks.
Second, the theory behind the formula also has fueledsome might say provokedspirited debate among
economists about the nature of investment risk itself. The CAPM attempts to describe how the market values
investments with expected returns.
The CAPM theory classifies risk as being either diversifiable, which can be avoided by sound investing,
or systematic, that is, not diversified and unavoidable due to the nature of the market itself. The theory
contends that investors are rewarded only for assuming systematic risk, because they can mitigate
diversifiable risk by building a portfolio of both risky stocks and sound ones.
One analysis has characterized the CAPM as a theory of equilibrium that links higher expected returns
in strong markets with the greater risk of suffering heavy losses in weak markets; otherwise, no one would
invest in high-risk stocks.

How It Works in Practice

CAPM holds that the expected return of a security or a portfolio equals the rate on a risk-free security plus
a risk premium. If this expected return does not meet or beat a theoretical required return, the investment
should not be undertaken. The formula used to create CAPM is:
Expected return = Risk-free rate + (Market return # Risk-free rate) Beta value
The risk-free rate is the quoted rate on an asset that has virtually no risk. In practice, it is the rate quoted for
90-day US Treasury bills. The market return is the percentage return expected of the overall market, typically
a published index such as Standard & Poors. The beta value is a figure that measures the volatility of a
security or portfolio of securities compared with the market as a whole. A beta of 1, for example, indicates
that a securitys price will move with the market. A beta greater than 1 indicates higher volatility, while a beta
less than 1 indicates less volatility.
Say, for instance, that the current risk-free rate is 4%, and the S&P 500 index is expected to return 11% next
year. An investment club is interested in determining next years return for XYZ Software Inc., a prospective
investment. The club has determined that the companys beta value is 1.8. The overall stock market always
has a beta of 1, so XYZ Softwares beta of 1.8 signals that it is a riskier investment than the overall market
represents. This added risk means that the club should expect a higher rate of return than the 11% for the
S&P 500. The CAPM calculation, then, would be:
4% + (11% # 4%) 1.8 = 16.6%
What the results tell the club is that given the risk, XYZ Software Inc. has a required rate of return of 16.6%,
or the minimum return that an investment in XYZ should generate. If the investment club doesnt think that
XYZ will produce that kind of return, it should probably consider investing in a different company.
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Tricks of the Trade

As experts warn, CAPM is only a simple calculation built on historical data of market and stock
prices. It does not express anything about the company whose stock is being analyzed. For example,
renowned investor Warren Buffett has pointed out that if a company making Barbie dolls has the
same beta as one making pet rocks, CAPM holds that one investment is as good as the other. Clearly,
this is a risky tenet.
While high returns might be received from stocks with high beta shares, there is no guarantee that their
respective CAPM return will be realized (a reason why beta is defined as a measure of risk rather
than an indication of high return).
The beta parameter itself is historical data and may not reflect future results. The data for beta values
are typically gathered over several years, and experts recommend that only long-term investors should
rely on the CAPM formula.
Over longer periods of time, high-beta shares tend to be the worst performers during market declines.

More Info
Article:

Burton, Jonathan. Revisiting the capital asset pricing model. Dow Jones Asset Manager (May/June
1998): 2028. Online at: www.stanford.edu/~wfsharpe/art/djam/djam.htm

Website:

Contingency Analysis resource for trading, financial engineering, and financial risk management:
www.contingencyanalysis.com

See Also
Best Practice

Valuation and Project Selection When the Market and Face Value of Dividends Differ
Checklists

Understanding the Relationship between the Discount Rate and Risk

Calculations

Expected Rate of Return

Finance Library

Portfolio Theory and Capital Markets

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