“Cap-M” looks at risk and rates of return and compares them to the overall stock market. If you use CAPM you have to assume that most investors want to avoid risk, (risk averse), and those who do take risks, expect to be rewarded. It also assumes that investors are “price takers” who can’t influence the price of assets or markets. With CAPM you assume that there are no transactional costs or taxation and assets and securities are divisible into small little packets. Had enough with the assumptions yet? One more. CAPM assumes that investors are not limited in their borrowing and lending under the risk free rate of interest. By now you likely have a healthy feeling of skepticism. We’ll deal with that below, but first, let’s work the CAPM formula.
Beta – Now, you gotta know about Beta. Beta is the overall risk in investing in a large market, like the New York Stock Exchange. Beta, by definition equals 1.0000. 1 exactly. Each company also has a beta. You can find a company’s beta at the Yahoo!! Stock quote page. A company’s beta is that company’s risk compared to the risk of the overall market. If the company has a beta of 3.0, then it is said to be 3 times more risky than the overall market.
Ks = Krf + B ( Km – Krf)
• Ks = The Required Rate of Return, (or just the rate of return).
• Krf = The Risk Free Rate (the rate of return on a “risk free investment”, like U.S. Government Treasury Bonds – Read our Disclaimer)
• B = Beta (see above)
• Km = The expected return on the overall stock market. (You have to guess what rate of return you think the overall stock market will produce.)
As an example, let’s assume that the risk free rate is 5%, and the overall stock market will produce a rate of return of 12.5% next year. You see that XYZ company (Read our Disclaimer) has a beta of 1.7.
What rate of return should you get from this company in order to be rewarded for the risk you are taking? Remember investing in XYZ company (beta =1.7) is more risky than investing in the overall stock market (beta = 1.0). So you want to get more than 12.5%, right?
• Ks = Krf + B ( Km – Krf)
• Ks = 5% + 1.7 ( 12.5% – 5%)
• Ks = 5% + 1.7 ( 7.5%)
• Ks = 5% + 12.75%
• Ks = 17.75%
So, if you invest in XYZ Company, you should get at least 17.75% return from your investment. If you don’t think that XYZ Company will produce those kinds of returns for you, then you would probably consider investing in a different stock
Who introduced the CAPM – Capital Asset Pricing Model?
Harry Markowitz worked on diversification and modern portfolio theory. Jack Treynor, John Lintner, Jan Mossin and William Sharpe all contributed to the theory of CAPM. William Sharpe, Harry Markowitz and Merton Miller jointly got a Nobel Prize in Economics for contributing to financial economics. See, if you study hard and think up new stuff maybe you can get a Nobel Prize too.
Ah, but CAPM has some flaws. (don’t we all)
• If you go to a casino, you basically pay for risk. It’s possible that the folks on Wall Street sometimes have the same mindset as well. Now remember that CAPM assumes that given “X%” expected return investors will prefer lower risk (in other words lower variance) to higher risk. And the opposite would be true as well – given a certain level of risk investors would prefer higher returns to lower ones. OK, but maybe the Wall Street people get a kick out of “gambling” their investment. Not saying it’s been proven to be the case, just saying it could be. CAPM doesn’t allow for investors who will accept lower returns for higher risk.
• CAPM assumes that asset returns are jointly normally distributed random variables. But often returns are not normally distributed. So large swings, swings as big as 3 to 6 standard deviations from the mean, occur in the market more frequently than you would expect in a normal distribution.
• CAPM assumes that the variance of returns adequately measures risk. This might be true if returns were distributed normally. However other risk measurements are probably better for showing investors’ preferences. Coherent risk measures comes to mind.
• With CAPM you assume that all investors have equal access to information and they all agree about the risk and expected return of the assets. This idea, by the way is called “homogeneous expectations assumption”. Be ready for your professor to ask, “What’s the Homogeneous Expectations Assumption and do you believe it’s valid”. Good luck with that one.
• CAPM can’t quite explain the variation in stock returns. Back in 1969, Myron Scholes, Michael Jensen and Fisher Black presented a paper suggesting that low beta stocks may offer higher returns than the model would predict.
• CAPM kind of skips over taxes and transaction costs. Some of the more complex versions of CAPM try to take this into consideration.
• CAPM assumes that all assets can be divided infinitely and that those small assets can be held and transacted.
• Roll’s Critique: Back in 1977, Richard Roll offered the idea that using stock indexes as a proxy for the true market portfolio can lead to CAPM being invalid. The true market portfolio should include stuff like real estate, human capital, works of art and so on, basically anything that anyone holds as an investment. However, the markets for those assets are often non-transparent and unobservable. So often financial people will use a stock index instead. Does it kind of seem like they are fudging a little bit. You might argue they are.
• CAPM assumes that individual investors have no preference for markets or assets other than their risk-return profile. But is that really the case? Say a guy loves drinking Coke. Only Coke. He’s collects old Coke bottles and stuff. OK, now, is that guy going to buy stock in Pepsi based only on its risk-return profile, or is he going to buy stock in Coke so he can brag to everyone about how many shares he has?