Dec 27

Capital Asset Pricing Model (CAPM)

by David Harper, CFA, FRM, CIPM

Quant |

If you want to quickly understand the capital asset pricing model (CAPM), open this animated graphic:

EngageScreenshot400w

The green arrows explain each element: the expected return, the riskless rate, beta, and the market equity premium. The two purple buttons show you two sample calculations. The red asterisk details the several restrictive assumptions.

The CAPM is not a very realistic model. But it plays a critical role in traditional portfolio theory. The CAPM is a one-factor model; that means that a security’s (stock’s) expected return is a linear function of only one factor, called beta. Beta is a measure of the stock’s sensitivity (or cross-volatility, or standardized covariance to be precise) to the overall market.

So the brilliance of the CAPM is that is explicitly linked risk and return. Riskier stocks, as evidenced by higher betas, ought to produce higher returns. Less risky stocks ought to produce lower returns. And an inflation-adjusted U.S. Treasury bond, having virtually no beta (i.e., sensitivity to market returns), ought to have a return equal to the riskless rate (because the second term zeros out).

Critics will note that beta is unreliable and the CAPM is not very useful. They could be right because, again, it’s only a one-factor model and we can hardly believe that only one factor captures all of a stock’s return (or put another way, that a single factor can impound all of a stock’s risk). Further, the several restrictions that are required by the CAPM relate to equilibrium theory. And equilibrium theory requires one more assumption: CAPM assumes that markets are efficient. So, all in, that’s a lot of requirements and you certainly don’t need to believe all of them. But you can still find use in the underlying idea, that expected return ought to be a function of risk.

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