The capital asset pricing model is a model which seeks to establish the relationship between the systematic risk of a security or a portfolio and its expected return.
Systematic risk refers to market risks which by rule of thumb cannot be diversified. Market risk entails interest rates, recessions and wars.
Capital asset pricing theory is the theory behind the pricing of assets which takes into account the risk and return characteristics of the asset and the market.
Capital asset pricing model is an equilibrium model that is a constant state model that underlies all modern financial theory.
It provides a precise prediction between the relationship between the risk of an asset and its expected return when the market is in equilibrium that is a balance or constant state.
With this model mispriced securities can be identified in the long run.
model provides a benchmark rate of return for evaluating possible investments and identifying potential mispricing of investments.
For example, an analyst might want to know whether the expected return he forecast is more or less than its fair market return.
It helps one to make an educated guess as to the expected return on assets that have not yet been traded in the marketplace.
The CAPM formula is the risk-free rate of return added to the beta of the security or portfolio multiplied by the expected market return minus the risk-free rate of return. This yields the expected return of the security.
The beta of a security measures the systematic risk and its sensitivity relative to changes in the market.
A security with a beta of one has a perfect positive correlation with its market. This indicates that when the market increases or decreases, the security increases or decreases in time with the market.
A security with a beta greater than 1 carries more systematic risk and volatility than the market, and a security with a beta less than 1 carries less systematic risk and volatility than the market.
The SML and CAPM formulas are useful in determining if a security being considered for an investment offers a reasonable expected return for the amount of risk taken on.
If a security’s expected return against its beta is plotted above the security market line, it is undervalued given the risk-return trade off.
Conversely, if a security’s expected return versus its systematic risk is plotted below the SML, it is overvalued because the investor would accept a smaller return for the amount of systematic risk associated with the portfolio.
However, CAPM is often criticised as unrealistic because of the assumptions on which the model is based, so it is important to be aware of these assumptions and the reasons why they are criticized.
It assumes that investors hold a diversified portfolio which means that investors will only require a return for the systematic risk of their portfolios, since unsystematic risk has been diversified and can be ignored.
It also assumes a single period transaction horizon. A standardised holding period is assumed by the CAPM to make the returns on different securities comparable.
A return over six months, for example, cannot be compared to a return over 12 months. A holding period of one year is usually used.
Moreover, CAPM assumes a perfect capital market. This assumption means that all securities are valued correctly and that their returns will plot on to the SML.
A perfect capital market requires the following: that there are no taxes or transaction costs; that perfect information is freely available to all investors who, as a result, have the same expectations that all investors are risk averse, rational and desire to maximise their own utility; and that there are a large number of buyers and sellers in the market.
The most critical assumption is that, investors can borrow and lend at the risk free rate of return. This is an assumption made by portfolio theory, from which the CAPM was developed, and provides a minimum level of return required by investors.
Based on the above assumptions all investors will hold the same portfolio for risky assets the market portfolio.
The market portfolio contains all securities and the proportion of each security is its market value as a percentage of total market value.
The risk premium on the market depends on the average risk aversion of all market participants.
The risk premium on an individual security is a function of its covariance, correlation and total risk with the market.
The risk premium on individual securities is a function of the individual security’s contribution to the risk of the market portfolio. Individual security’s risk premium is a function of the covariance of returns with the assets that make up the market portfolio.
Portfolio risk is what matters to investors, and portfolio risk is what governs the risk premiums they demand. Diversifiable risk can be reduced through diversification.
Investors need to be compensated for bearing only non-systematic risk that is risk that cannot be diversified away.
The contribution of a security to the risk of a portfolio depends only on its systematic risk, as measured by beta. So the risk premium of the asset is proportional to its beta.
Return and risk are linearly related for securities and portfolios over long periods of time.
Blessing Nyatanga holds a Bachelor’s Degree in Banking and Investment Management from NUST.0784909184/[email protected]