Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) quantifies a security’s value by evaluating the anticipated return in conjunction with the associated risk borne by investors upon investing in that security.
The model can be applied to all investment forms such as a stock, commodity, private equity startup, or mutual fund. Essentially, it applies to any investment entity that has a benchmark for comparative evaluation.
CAPM unveils the symbiotic relationship between risk and anticipated return, thereby enabling investors to compute security prices considering the expected rate of return and the cost of capital.
Historical Backdrop
Developed in the mid-1960s by William Sharpe, John Lintner, and Jan Mossin independently, CAPM has since been the cornerstone for myriad financial analyses and applications. It carved a niche by offering a mechanistic view of risk and return in a market equilibrium setting.
Understanding CAPM Formula
The CAPM formula is expressed as follows:
\[ r = R_f + \beta (R_m – R_f) + \alpha \]
Where:
- \( r \) is the expected return on the asset,
- \( R_f \) is the risk-free rate,
- \( \beta \) is the beta of the asset,
- \( R_m \) is the expected return of the market,
- \( \alpha \) is the alpha, representing the asset’s abnormal returns compared to the market.
Core Components of CAPM
Now let’s delve into each of these components:
- Expected Return (\( r \)):
The return investors anticipate on the asset for a given period. - Risk-free Rate (\( R_f \)):
Typically embodied by the yield on a government bond, it’s the return investors would expect with zero risk. In the Indian market, the risk-free return is often represented by the yield on a 10-year Government of India bond. This bond is deemed to be free of credit risk, as it’s backed by the sovereign guarantee. - Beta (\( \beta \)):
A measure of the asset’s sensitivity to the overall market movements. A beta of 1 indicates the asset moves in tandem with the market, while a beta greater or lesser than 1 signifies the asset is more volatile or less volatile, respectively. - Expected Market Return (\( R_m \)):
The anticipated return of the market over a specified period. - Alpha (\( \alpha \)):
The abnormal return of the asset compared to the market, often seen as a reflection of the asset manager’s performance.
Market Risk Premium (\(R_m – R_{rf}\))
The market risk premium in the Indian context encapsulates the additional return that investors anticipate by investing in a diversified portfolio such as the NSE Nifty 50 or BSE Sensex, over the risk-free rate. The difference between the historical average return of such market indices and the risk-free rate represents the market risk premium.
Advantages And Disadvantages
CAPM serves multiple purposes in the financial arena:
Merits
Systematic Risk Measurement: CAPM provides a quantifiable measure of systematic risk (beta) for individual securities relative to the overall market, helping investors understand the risk profile of their investments.
Expected Return Estimation: It aids in estimating the expected return on an investment, given the risk-free rate, the beta of the security, and the expected market return. This is crucial for making informed investment decisions.
Cost of Equity Calculation: CAPM is instrumental in calculating the cost of equity, which is a key input for evaluating a company’s weighted average cost of capital (WACC).
Comparative Analysis: Allows for comparative analysis between different securities, aiding in portfolio construction and management.
Market Risk Premium: Highlights the market risk premium, which is the additional return investors expect for taking on extra market risk.
Demerits
Idealistic Assumptions: Operates under certain idealistic assumptions like a risk-free rate and a single-period transaction horizon which may not hold true in real-world scenarios.
Beta Instability: Beta coefficients, which are central to this model, are unstable and can change over time, potentially leading to inaccurate estimations of expected returns.
Single-Factor Model: CAPM is a single-factor model that only considers market risk, ignoring other factors that might affect a security’s return.
Historical Data Dependency: Relies heavily on historical data for beta and market return estimations which might not be a good predictor for future performance.
Exclusion of Unsystematic Risk: Overlooks unsystematic risk which is the risk inherent to a particular security or company, potentially leading to underestimation of total risk.
Examples
Let’s dive into a few CAPM’s examples to grasp the concept thoroughly.
Example #1
Consider a stock listed on the Bombay Stock Exchange (BSE) with operations spread across India. Assuming the yield on a 10-year Government of India bond is 6.5%, historical data suggesting an earning of 15%, and a Beta of 1.4, the expected rate of return is calculated as follows:
\[ \text{Expected return} = 6.5\% + 1.4 * (15\% – 6.5\%) = 18.9\% \]
Example #2
Suppose an investor contemplates investing in either Stock Reliance or Stock TCS, utilizing CAPM, the investor finds the expected rate of return for Stock Reliance to be 20% and for Stock TCS to be 18%. Thus, investing in Stock Reliance would be a slightly more lucrative option, assuming all other factors remain constant.
These illustrations provide a glimpse into how CAPM can be utilized in the Indian market scenario to make informed investment decisions by calculating the expected rate of return on different securities.
Basic Assumptions of CAPM
Merits
Perfect Competition: The market operates in a state of perfect competition where all investors are price takers, meaning they accept the market price and cannot influence it due to their trading activities.
Homogeneous Expectations: All investors have identical expectations regarding the future prospects of available investments. This means they forecast the same expected returns, variances, and covariances for each asset.
Frictionless Markets: There are no transaction costs or taxes, enabling investors to trade securities without incurring any additional expenses.
Demerits
Market Efficiency:
There are no market imperfections such as monopolies, implying that information is freely available to all market participants, allowing markets to adjust quickly to new information.
Infinite Investment Horizon:
Investors are assumed to have identical time horizons, which are infinitely long, ensuring a uniform evaluation of investment opportunities.
Single Risky Asset:
The market consists of one risky asset whose returns remain constant over time, simplifying the analysis by eliminating the impact of multiple assets with varying risk profiles.