What is the Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) refers to the model that explains the relationship between expected return and risk of investing in security (asset). This model is widely used throughout finance for pricing risky securities and producing expected returns for assets given the risk of those assets and cost of capital.
The capital asset pricing model states that the investor must compensate in two ways: the time value of money and risk. The time value of money means that the present value of money is more than its value in the future. Thus, an investor is salaried for hiring a certain amount of money in a specific investment over a period of time. Another part of the formula consists of a risk. The investor must be paid for the additional risk that he tolerates by allowing his funds in a particular investment. The risk is represented by beta (β).
The capital asset pricing is given by the following equation:
Ra = Rf + β(rm-rf)
Ra= return on asset
Rf= risk free rate
(β)= risk premium
The rm= market rate of return
Assumptions of Capital Asset Pricing Model
- Investors are risk averse, i.e. funds are placed in investments with the least
- All the shareholders have the same beliefs from the market and are well-informed.
- No stakeholder is big enough to affect the security price.
- The market is perfect; no taxes, no transaction costs, and competitive market.
- Unlimited amounts can be borrowed or lent at a risk-free rate.
Advantages of CAPM
There are numerous benefits to the application of CAPM, including:
- Ease of use: CAPM is a basic calculation that can be stress-tested easily in order to develop a range of expected results to provide confidence around the required rates of return.
- Diversified portfolio: The statement that the shareholders hold varied portfolio, parallel to the market portfolio, eradicates unsystematic risk.
- Systematic Risk (beta): CAPM takes in consideration systematic risk, that is left out of other models, like that of the dividend discount model (DDM). The systematic risk is an essential variable because it is unpredicted and cannot be reduced fully.
- Business and Financial Risk Variability: At the time of investigating the business opportunities, if the business mix and financing differ from the current business, then, other required return calculations, like weighted average cost of capital (WACC), cannot be used.
Drawbacks of CAPM
The primary drawbacks are revealed in the model’s inputs and assumptions, including:
- Risk-free Rate (Rf): The commonly accepted rate used as the Rf is the yield on short-term government securities. The issue with using this input is that the yield changes daily, creating volatility.
- Return on market (Rm): The return on the market can be described as the sum of capital gains and dividends for the market. the problem arises when at any given time, the market return is negative.
- Ability to borrow at a risk-free rate: CAPM stands on four assumptions, including one that reflects an unrealistic real-world picture. This assumption, that the shareholders can borrow and lend at a risk-free rate, is unreachable in reality.
- Determination of project proxy beta: The businesses that use CAPM to evaluate investment need to find a beta reflective to the project or investment, proxy beta is essential. Exactly influencing one to properly assess the project is hard and may affect the reliability of the result.