CAPM

Definition

The Capital Asset Pricing Model (CAPM) is a financial model that establishes a linear relationship between the expected return of an asset and its systematic risk, represented by beta. It suggests that the expected return on an investment is equal to the risk-free rate plus a risk premium that is proportional to the asset's beta, which measures its sensitivity to market movements. The model helps in understanding how assets are priced in relation to their risk, contributing to discussions about market efficiency and investor behavior.

5 Must Know Facts For Your Next Test

1. CAPM is built on the assumption that investors are rational and markets are efficient, meaning all available information is reflected in asset prices.
2. The model helps to explain the security market line (SML), which visually represents the relationship between expected return and systematic risk.
3. CAPM is used widely in finance for portfolio management, capital budgeting, and estimating required returns on investments.
4. One challenge with CAPM is that it assumes a single-period investment horizon, which may not reflect real-world scenarios where investments span multiple periods.
5. Empirical tests of CAPM have produced mixed results, raising questions about its validity and leading to the development of alternative models like the Fama-French Three-Factor Model.

Review Questions

• How does CAPM explain the relationship between risk and return for assets in an efficient market?
  • CAPM explains that in an efficient market, investors expect higher returns for taking on additional risk. The model posits that the expected return on an asset is determined by the risk-free rate plus a risk premium based on the asset's beta. This means that assets with higher systematic risk (higher beta) should yield higher expected returns compared to less risky assets. The linear relationship illustrated by CAPM helps investors assess whether they are being adequately compensated for the risks they undertake.
• Discuss the limitations of CAPM and how they challenge its applicability in real-world scenarios.
  • While CAPM provides a foundational understanding of risk and return, it has several limitations that challenge its real-world applicability. For instance, it relies on assumptions such as rational investor behavior and efficient markets, which may not always hold true. Additionally, CAPM considers only systematic risk, ignoring factors like liquidity risk or specific company risks. Empirical tests have shown inconsistencies with predicted returns, prompting researchers to explore alternative models that incorporate multiple factors influencing asset prices.
• Evaluate how empirical challenges to market efficiency impact the reliability of CAPM as a pricing model.
  • Empirical challenges to market efficiency significantly impact the reliability of CAPM as a pricing model because if markets are not fully efficient, then asset prices may not accurately reflect their true risks as assumed by CAPM. For example, anomalies such as excess returns from small-cap stocks or value stocks contradicting CAPM predictions suggest that other factors beyond systematic risk may affect returns. As a result, these challenges call into question whether CAPM can consistently provide accurate estimates of expected returns in markets where behavioral biases or information asymmetries exist.

Related terms

Beta: A measure of an asset's volatility in relation to the overall market, indicating how much the asset's price changes compared to market movements.

Risk-Free Rate: The theoretical return on an investment with zero risk, typically represented by government bonds, used as a baseline for evaluating investments.

Market Portfolio: A theoretical portfolio that includes all available risky assets in the market, weighted according to their market capitalization, representing the overall market's risk-return profile.