Capital Asset Pricing Model (CAPM)
Introduction
Can you explain the components of the capital asset pricing model (CAPM)? Read this section and take notes on how the CAPM is used to calculate the expected
equired rate of return on a security.
Of course, any given observation might deviate from the relationship predicted (beta is a statistical number), but the key idea is that our expected returns should hold to this relationship. If we rea
ange this equation to solve for the expected return of stock A, we get what is called the capital asset pricing model (CAPM):
Capital Asset Pricing Model (CAPM)
A−rRFβA=rMKT−rRFrA=βA×(rMKT−rRF)rA=rRF+βA(rMKT−rRF)rA−rRFβA=rMKT−rRFrA=βA×(rMKT−rRF)rA=rRF+βA(rMKT−rRF)
This is a very important result, as it implies that we can predict a stock’s expected return if we know the risk-free rate, beta of the stock, and the market-risk premium.
Thus, if stock GHI has a beta of 1.2, and we know that the risk-free rate is 2% and the expected market returns are 7%, the expected returns for GHI should be XXXXXXXXXX × (0.07 − 0.02) = 0.08 or 8%.
We can also use the relationship to compare two stocks directly:
Proportional Risk Premiums (Two Stocks)
Issues With CAPM
Although the relationship embodied in CAPM is very important to understand, the theory is not without its limitations. Determining the expected risk-free rate is fairly accurately obtained from observing the bond market (typically using long-term U.S. government bond yields as a proxy), but figuring an accurate forward-looking beta and equity-risk premium is much more difficult. The bulk of estimates of the equity-risk premium in the United States fall in the 2%–5% range, though arguments for rates well outside this range are not unheard of!
As a more general critique, there are proposals that there are systematic risk factors beyond just market risk. For example, some multifactor models (such as including a variable for company size) seem to be better predictors of expected returns. Ideally, the market portfolio should not just include stocks, but the entire field of investments (including real estate, fine art, and even baseball cards). Empirically, CAPM is not as accurate as we wish it to be in predictive power.
Note. Adapted from “The Capital Asset Pricing Model (CAPM),” by Scott, A. K. S. and Barnhorst, B. C., 2014, Managerial Finance, Chapter 11, Section 6. Copyright 2014 Flat World Knowledge, Inc.