9.3 Capital Asset Pricing Model (CAPM)
3 min read•august 6, 2024
The Capital Asset Pricing Model (CAPM) is a crucial tool in finance for understanding the relationship between risk and . It builds on portfolio theory by introducing the concepts of and , helping investors assess how individual securities fit into a diversified portfolio.
CAPM introduces key elements like the , market , and beta to calculate expected returns. By comparing a security's to its actual performance, investors can identify undervalued or overvalued assets and make informed investment decisions.
Beta and Systematic Risk
Measuring Systematic Risk with Beta
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- Beta coefficient measures the sensitivity of a security's returns to changes in the returns of the overall market
- Represents the systematic or non- of a security
- Calculated by dividing the covariance between the security's returns and the market's returns by the variance of the market's returns
- Securities with betas greater than 1 are more volatile than the market (aggressive), while securities with betas less than 1 are less volatile (defensive)
Market Risk and Risk Premium
- Systematic risk, also known as market risk, refers to the risk inherent in the entire market that cannot be diversified away
- Affects all securities in the market to varying degrees depending on their beta
- Market risk premium is the excess return that investors require for holding a over a risk-free asset
- Calculated as the difference between the expected return on the market portfolio and the risk-free rate (historical average of S&P 500 returns minus Treasury bill returns)
Portfolio Diversification and Market Portfolio
- Investors can reduce unsystematic risk through portfolio but cannot eliminate systematic risk
- Market portfolio represents a theoretical portfolio that includes all risky assets in the market, weighted proportionally to their market capitalization
- Serves as a benchmark for evaluating the performance of individual securities and portfolios
- In practice, broad market indices like the S&P 500 or Russell 3000 are used as proxies for the market portfolio
Risk-Free Rate and Expected Return
Risk-Free Rate and Security Market Line
- Risk-free rate is the theoretical rate of return on an investment with zero risk, typically approximated by the yield on short-term government securities (Treasury bills)
- Represents the minimum return an investor expects for any investment because they will not accept additional risk without additional compensation
- (SML) is a graphical representation of the Capital Asset Pricing Model (CAPM) that shows the relationship between an asset's expected return and its beta
- SML equation: Expected return = Risk-free rate + Beta * (Market risk premium)
Expected Return and Alpha
- Expected return is the return an investor anticipates receiving on an investment, considering the asset's level of risk
- In CAPM, the expected return of a security is determined by the risk-free rate, the security's beta, and the market risk premium
- Securities that plot above the SML are considered undervalued because they offer higher returns than what their risk level suggests, while securities below the SML are overvalued
- measures the excess return of a security or portfolio relative to its expected return based on its level of systematic risk (beta)
- Positive alpha indicates that a security has outperformed its benchmark index on a risk-adjusted basis, while negative alpha indicates underperformance
Key Terms to Review (21)
Alpha: Alpha is a measure of an investment's performance on a risk-adjusted basis, indicating the excess return generated relative to a benchmark or expected return. It helps investors gauge how well a portfolio or asset has performed compared to what would be expected given its risk level, often associated with the Capital Asset Pricing Model (CAPM). A positive alpha signifies that an investment has outperformed its benchmark, while a negative alpha indicates underperformance.
Arbitrage Pricing Theory: Arbitrage Pricing Theory (APT) is a financial model that explains the relationship between an asset's expected return and its risk factors, using multiple variables instead of relying on a single market risk factor. It provides a framework for understanding how various macroeconomic and firm-specific factors can impact the pricing of assets, allowing investors to identify arbitrage opportunities based on mispricing in the market. APT is particularly useful in contrasting the simpler Capital Asset Pricing Model (CAPM), which focuses only on market risk.
Asset valuation: Asset valuation is the process of determining the worth or value of an asset, which can be critical for investment decisions, financial reporting, and corporate finance strategies. This involves analyzing various factors such as market conditions, income potential, and risks associated with the asset. Accurate asset valuation is essential in understanding the expected returns and assessing the risk profile of investments, especially when using models that quantify risk and return relationships.
Beta: Beta is a measure of a stock's volatility in relation to the overall market. It indicates how much the stock's price is expected to change when the market moves, helping investors assess risk and make informed decisions about investment strategies and portfolio management.
Capital Market Line: The Capital Market Line (CML) represents the relationship between the expected return and risk of efficient portfolios that can be constructed using a mix of the market portfolio and risk-free assets. It illustrates how investors can achieve optimal portfolios by combining the risk-free rate with the market portfolio, showcasing the trade-off between risk and return in capital markets.
Diversifiable Risk: Diversifiable risk, also known as unsystematic risk, refers to the portion of an asset's risk that is unique to a particular company or industry and can be mitigated through diversification. By holding a well-diversified portfolio of assets, investors can reduce this type of risk, as the negative performance of one investment may be offset by the positive performance of others. This concept plays a crucial role in investment strategies and the overall understanding of risk in the context of finance.
Diversification: Diversification is the strategy of spreading investments across various financial assets or sectors to reduce overall risk. By diversifying, investors aim to lower the impact of poor performance in any single investment by balancing it with better-performing assets. This approach not only helps in risk management but also optimizes returns over time, making it a crucial concept in financial decision-making.
Efficient Market Hypothesis: The Efficient Market Hypothesis (EMH) is a financial theory suggesting that asset prices fully reflect all available information at any given time, making it impossible to consistently achieve higher returns than the overall market through expert stock selection or market timing. This idea challenges the concept of undervalued or overvalued securities and plays a critical role in investment strategies, portfolio management, and risk assessment.
Expected return: Expected return is the anticipated profit or loss an investor expects to earn from an investment over a specific period, usually expressed as a percentage. It takes into account the various possible outcomes of an investment, weighted by their probabilities, and reflects both risk and reward, making it a crucial concept in understanding how investments can generate value.
Expected Return: Expected return is the anticipated return on an investment based on its historical performance and the likelihood of future outcomes. This concept plays a crucial role in understanding how risk and return interact in investment decisions, providing investors with a benchmark to evaluate potential investments. By estimating expected returns, investors can assess whether the potential reward justifies the risks they are taking.
John Lintner: John Lintner was an influential American economist known for his significant contributions to finance, particularly the development of the Capital Asset Pricing Model (CAPM). His work provided a framework for understanding the relationship between risk and expected return in asset pricing, which has become fundamental in modern financial theory and investment analysis.
Market Equilibrium: Market equilibrium is a state in a market where the quantity of a good or service demanded by consumers equals the quantity supplied by producers, resulting in a stable price level. This balance ensures that there are no shortages or surpluses, creating an efficient allocation of resources. In the context of investment and risk, understanding market equilibrium is crucial for determining expected returns and assessing asset pricing models.
Market portfolio: A market portfolio is a theoretical portfolio that includes all available assets in the market, weighted according to their market values. This concept is central to modern portfolio theory and underpins the Capital Asset Pricing Model (CAPM), as it represents the optimal combination of risky assets that investors can hold, capturing the overall market risk.
Market return: Market return refers to the average return on an investment portfolio, usually represented by a market index such as the S&P 500, over a specific period. This concept is crucial for investors as it serves as a benchmark to evaluate the performance of individual securities against the broader market, influencing investment decisions and strategies.
Portfolio management: Portfolio management is the process of creating and managing a collection of investments to meet specific financial goals. It involves making decisions about asset allocation, investment selection, and risk management to optimize returns while minimizing risk. Effective portfolio management takes into account the relationship between various assets, allowing for a balanced approach to investment that aligns with the investor's risk tolerance and financial objectives.
Risk premium: The risk premium is the additional return an investor demands for taking on the risk of an investment compared to a risk-free asset. This concept highlights the relationship between risk and expected return, as investors need to be compensated for the uncertainty and volatility associated with higher-risk assets, which could include stocks or bonds. Understanding the risk premium helps in making informed investment decisions and assessing the potential rewards versus risks involved.
Risk-free rate: The risk-free rate is the theoretical return on an investment with zero risk, often represented by the yield on government securities like U.S. Treasury bonds. It serves as a benchmark for evaluating the expected returns of riskier investments, forming a crucial component in financial models and investment decision-making processes.
Security Market Line: The Security Market Line (SML) is a graphical representation of the Capital Asset Pricing Model (CAPM), illustrating the relationship between systematic risk, measured by beta, and expected return for individual securities. It serves as a benchmark for evaluating the expected return of an asset compared to its risk, allowing investors to assess whether a security is overvalued or undervalued in relation to the market.
Sharpe Ratio: The Sharpe Ratio is a measure used to assess the risk-adjusted return of an investment, calculated by subtracting the risk-free rate from the return of the investment and then dividing that result by the standard deviation of the investment's returns. This ratio helps investors understand how much extra return they are receiving for the additional volatility they endure compared to a risk-free asset. It plays a crucial role in portfolio optimization and asset pricing models, allowing investors to make more informed decisions about their investments.
Systematic risk: Systematic risk refers to the inherent risk that affects the entire market or a particular segment of the market, and it cannot be eliminated through diversification. This type of risk is often associated with macroeconomic factors such as interest rates, inflation, and geopolitical events that impact all assets to some degree. Understanding systematic risk is crucial for investors as it helps them gauge the overall market volatility and potential returns of their investments.
William Sharpe: William Sharpe is a prominent American economist known for his contributions to finance, particularly for developing the Capital Asset Pricing Model (CAPM) and co-creating the Sharpe Ratio. His work has had a profound impact on investment management and portfolio theory, influencing how risk and return are evaluated in financial markets.