A Look At The Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between risk and expected return and is used to price risky securities. It does this by using math and it clarifies the relationship between risk and return in an ideal, that is, rational, equilibrium market. The model was developed by economists but has been used in a wide variety of settings from corporate budgets to public utility pricing rate setting. For Mutual Funds, CAPM has been used to justify passive investing. CAPM was developed in the 1960s, independently by three different researchers, Sharpe, Lintner and Mossin. At first, the theory was treated skeptically and with some suspicion, as it seemed to go against the investment ethos of the time, which emphasized professional investment management. It took a decade but eventually the business community came around.
The crucial part of the model is that it divorces the risk that affects an asset into two categories — unsystematic risk, which is specific to the company, and systematic risk, which is generalized risk associated with the overall economy. The model says that the return on an asset should, on average, be the same as the yield on a risk-free bond being held for the same time, plus a premium that is proportional to the amount of risk (systematic) that the business asset possesses.
Systematic vs. Unsystematic Risk
Contemporary portfolio theory states that diversification can deal with and mitigate unsystematic risk. The idea is that by having a diverse group of assets random in fluctuations in one set of assets will be offset by opposite type of fluctuations in other assets. For example, say a soda business messes up and their customers turn on them for a time. This will drive down the value of the business’s stock. These customers will switch to a rival business, which will drive up that business’s value. For an investor in both businesses the fluctuations should, at the very least, offset each other.
Systematic risk, on the other hand, cannot be mitigated by diversification as unpredictable movements in the economy cause it. It is risk that anyone has to deal with when they set out to do business. It does not matter the quality of the business’s product or how good the leadership, profitability is ultimately heavily influenced by business trends that they cannot control.
With CAPM the risk associated with some sort of asset is measured vis-à-vis the risk of the overall market. The market return is typically characterized by an equity index. A well known index is the Standard and Poor’s 500.
How CAPM Works
The Model indicates that the expected return of an asset is the same as the rate on a risk-free security plus a premium for the risk. The Capital Asset Pricing Model models return on an asset by three guidelines. Guideline one is that all assets need to have an expected return that is equal to or better than the return to a risk-free bond. There are exceptions but they are very rare. Second, there is no expectation for returns vis-à-vis unsystematic risk since this risk can be simply avoided. Diversification is not difficult to do and only helps investors who have the assets. Therefore, there is no expected gain to taking unnecessary risk by keeping the assets in isolation. Lastly, the model holds that assets exposed to systematic risk are expected to earn a return that is higher than the risk-free rate. This sort of risk cannot be covered by diversification and has to be handled by the investor if they are going to use the asset productively. The higher the risk the greater the average long-term return has to be for the person accepting the risk. Some assets have negative premiums. This means that the asset has an expected return that is less than the risk free rate. Assets with negative returns can be used to hedge against the general economic risk, meaning that they can do better when the economy is doing bad over all. A good example is precious metals.
Strengths and Weaknesses
Since the 1970s, academics have spent a great deal of time researching the strengths and weaknesses of the underlying assumptions. The assumptions that make up the basis of CAPM are the following:
1. Investors measure the risk of an asset by the variance in the return over future periods. Other forms of risk measures are irrelevant
2. Investors are typically risk averse and want to maximize return. The more return the better and the less risk the better.
3. At a risk free rate of interest, there are no restrictions on money borrowing and lending.
4. All possible forms of investments are traded in the market and everyone can access them. There are no limitations on how an asset can be devised and there are no limitations on short selling.
5. The market’s efficiency is perfect. Every investor has access to and comprehension of the identical information can process it accurately and can trade without cost. Taxation is not considered.
Early tests of the model showed that, at least conceptually, the model was sound. The exception was that the Security Market Line intercept. This was estimated to be about 3 – 4% higher than the risk free rate. However, if the Capital Pricing Asset Model is modified to account for not being able to borrow at a risk-free rate, this finding will fit the model.