Simplifying what is CAPM – Capital Asset Pricing Model: One of the most popular and prevalent laws states that “Greater the risk, greater the reward”. This holds true even when we take into account the stock market and the returns earned. Assets like government bonds come with low risk-low returns, blue-chip equities come with medium risk- medium return, and high risk-returns in equity stock is generally noticed with new entrants.
All seems well and good when we are able to compare different asset classes as above. But how would you differentiate the expected returns between stocks of the same asset class? And even when done among different asset classes how is this differentiation quantifiable?
Today, we discuss the CAPM an investment theory that provides the answers to these very problems. The model has been so integral to financial management that it has even been suggested that finance became a full-fledged scientific discipline’ only when William Sharpe published his derivation of the CAPM in 1986.
What is CAPM?
The Capital Asset Pricing Model provides us with a formula that describes the relationship between expected return and the risk of investing in that security. The CAPM formula provides investors with an expected return that they should be expecting taking up the risk on the security.
On the other hand, it is also used by the management of the company to calculate the cost of equity or the rate at which the will service the shareholder equity in order to fairly compensate its shareholders for taking up the risk.
How to Calculate returns using CAPM?
The expected return for security can be calculated using the following formula:
- Rf = Risk-Free Rate
- Rm = Expected return of the market
- Ra = Expected return from the security.
Simplifying the Expected Return Calculation Formula
A first glimpse of the formula shown above is good enough to spin heads. Now we go ahead and simplify it in order to make it more understandable.
1. Rf = Risk-Free Rate
Generally, government-issued bonds are known to be one of the most secure investments. This is why the rate provided by these government bonds is termed as the risk-free rate.
2. Beta – Stock’s volatility Measure
Beta here is the measure of the stock’s risk which is captured by measuring the volatility a stock faces in relation to the overall market. Here the average market return is 1. Say the Beta of a company A is 1.5. This would mean that for every 1% increase in the market return the shares of A’ will increase by 1.5%. But also a 1% decrease would mean that shares of A will decrease by 1.5%. Stocks like this are highly volatile.
Take another example where the Beta of a company is 0.5. This would mean that for every 1% increase in the market return the shares of A’ will increase by 0.5%. But also a 1% decrease would mean that shares of A will decrease by 0.5%. Stocks like this are of low volatility.
3. Rm = Expected return of the market
The expected return from the market is achieved by either following what research companies estimate. Or by computing historical averages from the past say for eg. the average Nifty return for the last 10 years. This is used in the formula in order to find the market risk premium. The market risk premium is shown in the formula as (Rm-Rf). This in simpler words shows the additional return available from the market in comparison to the Risk-Free rate.
After reading the above the formula simply becomes,
Expected Return from the Mkt. = Risk-Free Rate + (Beta * Market Risk Premium)
A Simple Example to Understand it further
Let us calculate the expected rate of return for ABC company. Say the risk-free rate is 3% by looking into the current government-issued bond rates. ABC operates in the textile industry which has a Beta of 1.3%. Indian Markets, on the other hand, are expected to rise in value by 8% per year.
Here, the expected return rate can be calculated as,
Expected Return from the Mkt. = Risk-Free Rate + (Beta * Market Risk Premium) = 3% + 1.3 * (8% – 3%) = 9.5%
Assumptions of the CAPM
Before concluding this article, let us also discuss a few of the assumptions considered during CAPM calculations:
- All investors have relevant information about the companies.
- All investors are rational, risk-averse, and seek to maximize their returns from investments.
As in most cases, the assumptions are unrealistic in the real world turning them into limitations of the model.
In this article, we tried to simplify what is CAPM i.e. Capital Asset Pricing Model. This approach has both its pros and cons while calculating the expected rate of return of an asset.
Over the years a number of shortcomings have come about with regards to the CAPM but it still remains widely used because of its simplicity and ease of comparison of investment alternatives. The CAPM however does not remain restricted to finding expected returns but is also used in portfolio building by investors. Its key advantages however will always lie in its ability to translate into estimates of expected return, keeping it useful.