Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

You’ll never know the days, the nights, the tears, the tears I’ve cried – Tina Turner

No finance students goes through graduate or even undergraduate school without learning about the Capital Asset Pricing Model (CAPM). The CAPM formula involves a risk free rate, beta of the security and expected market return. The model is used in assessing risk and compare it to expected return and thus in determining the best price for risky securities. The model rests on the basic assumption that investors must be compensated in terms of value of money as well as of the risk they undertake.

In other words, the CAPM model attempts to predict whether a investment should be made according to the risk that it involves. Risk is seen as an inherent part of investing. For example, some individuals are risk averse, while others are risk tolerant. Such different character traits correspond to diverse investor profiles, and are likely to result in very different portfolios. In general, the more risk is involved, the more growth and income, but as with any subject, it is better to refrain from simplistic conclusions.

We will stand tall – Adele. RBC Dominion Securities. Image: Elena

Typically, diversification is seen as a method of reducing risk (modern portfolio theory). However, usually diversification cannot eliminate risk completely. Thus, the next best thing is for investors to be compensated for the risk they take on by a corresponding rate of return. Therefore, CAPM is a model showing the rate of return that should justify the particular security. Notwithstanding, much of theory is debated. Financial theories are no different. Hence, the CAPM model remains likewise argued about in the literature.

Historically, the CAPM was developed and introduced by financial economist William Sharpe in his book Portfolio Theory and Capital Markets. According to the theoretical construct, there are two types of risk: systematic and unsystematic. The CAPM is designed to compute systematic risk.