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As

investors, we deserve a rate of return that compensates us for taking on risk. The capital asset

pricing model (CAPM) helps us to calculate investment risk and what return on investment we

should expect. Here we look at the formula behind the model, the evidence for and against the

accuracy of CAPM, and what CAPM means to the average investor.

Birth of a Model

The capital asset pricing model was the work of financial economist (and, later, Nobel laureate in

economics) William Sharpe, set out in his 1970 book "Portfolio Theory And Capital Markets."

His model starts with the idea that individual investment contains two types of risk:

1. Systematic Risk - These are market risks that cannot be diversified away. Interest rates,

recessions and wars are examples of systematic risks.

2. Unsystematic Risk - Also known as "specific risk," this risk is specific to individual

stocks and can be diversified away as the investor increases the number of stocks in his or

her portfolio. In more technical terms, it represents the component of a stock's return that

is not correlated with general market moves.

Modern portfolio theory shows that specific risk can be removed through diversification. The

trouble is that diversification still doesn't solve the problem of systematic risk; even a portfolio of

all the shares in the stock market can't eliminate that risk. Therefore, when calculating a deserved

return, systematic risk is what plagues investors most. CAPM, therefore, evolved as a way to

measure this systematic risk. (To learn more, see Modern Portfolio Theory: An Overview.)

The Formula

Sharpe found that the return on an individual stock, or a portfolio of stocks, should equal its cost

of capital. The standard formula remains the CAPM, which describes the relationship between

risk and expected return.

Here is the formula:

CAPM's starting point is the risk-free rate - typically a 10-year government bond yield. To this is

added a premium that equity investors demand to compensate them for the extra risk they accept.

This equity market premium consists of the expected return from the market as a whole less the

risk-free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called

"beta."

Beta

According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's

relative volatility - that is, it shows how much the price of a particular stock jumps up and down

compared with how much the stock market as a whole jumps up and down. If a share price

moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would

rise by 15% if the market rose by 10%, and fall by 15% if the market fell by 10%. (For further

reading, see Beta: Gauging Price Fluctuations and Beta: Know The Risk.)

Beta is found by statistical analysis of individual, daily share price returns, in comparison with

the market's daily returns over precisely the same period. In their classic 1972 study titled "The

Capital Asset Pricing Model: Some Empirical Tests," financial economists Fischer Black,

Michael C. Jensen and Myron Scholes confirmed a linear relationship between the financial

returns of stock portfolios and their betas. They studied the price movements of the stocks on the

New York Stock Exchange between 1931 and 1965.

Beta, compared with the equity risk premium, shows the amount of compensation equity

investors need for taking on additional risk. If the stock's beta is 2.0, the risk-free rate is 3% and

the market rate of return is 7%, the market's excess return is 4% (7% - 3%). Accordingly, the

stock's excess return is 8% (2 X 4%, multiplying market return by the beta), and the stock's total

required return is 11% (8% + 3%, the stock's excess return plus the risk-free rate).

What this shows is that a riskier investment should earn a premium over the risk-free rate - the

amount over the risk-free rate is calculated by the equity market premium multiplied by its beta.

In other words, it's possible, by knowing the individual parts of the CAPM, to gauge whether or

not the current price of a stock is consistent with its likely return - that is, whether or not the

investment is a bargain or too expensive.

This model presents a very simple theory that delivers a simple result. The theory says that the

only reason an investor should earn more, on average, by investing in one stock rather than

another is that one stock is riskier. Not surprisingly, the model has come to dominate modern

financial theory. But does it really work?

It's not entirely clear. The big sticking point is beta. When professors Eugene Fama and Kenneth

French looked at share returns on the New York Stock Exchange, the American Stock Exchange

and Nasdaq between 1963 and 1990, they found that differences in betas over that lengthy period

did not explain the performance of different stocks. The linear relationship between beta and

individual stock returns also breaks down over shorter periods of time. These findings seem to

suggest that CAPM may be wrong.

While some studies raise doubts about CAPM's validity, the model is still widely used in the

investment community. Although it is difficult to predict from beta how individual stocks might

react to particular movements, investors can probably safely deduce that a portfolio of high-beta

stocks will move more than the market in either direction, and a portfolio of low-beta stocks will

move less than the market.

This is important for investors - especially fund managers - because they may be unwilling to or

prevented from holding cash if they feel that the market is likely to fall. If so, they can hold lowbeta stocks instead. Investors can tailor a portfolio to their specific risk-return requirements,

aiming to hold securities with betas in excess of 1 while the market is rising, and securities with

betas of less than 1 when the market is falling.

Not surprisingly, CAPM contributed to the rise in use of indexing - assembling a portfolio of

shares to mimic a particular market - by risk averse investors. This is largely due to CAPM's

message that it is only possible to earn higher returns than those of the market as a whole by

taking on higher risk (beta). (To learn more, see The Lowdown On Index Funds.)

Conclusion

The capital asset pricing model is by no means a perfect theory. But the spirit of CAPM is

correct. It provides a usable measure of risk that helps investors determine what return they

deserve for putting their money at risk. To learn more, see Achieving Better Returns In Your

Portfolio.

Read more: The Capital Asset Pricing Model: An Overview | Investopedia

http://www.investopedia.com/articles/06/capm.asp#ixzz43DmGKZDm

Follow us: Investopedia on Facebook

Capital Market Line

One of the assumptions of Modern Portfolio Theory (MPT) is that all investors have the same

market expectations; given that, we can talk about the expected return on a portfolio, and the

Sharpe ratio, and so on. Amongst all of the possible risky portfolios, there is (at least) one that

has the highest Sharpe ratio. (Most people say that there is one such portfolio, but it is

theoretically possible to have more than one; its not a big deal either way.) That portfolio will

lie on the efficient frontier (see the graph below), and is called the Market Portfolio. (Some

people think that this is the portfolio with all investible assets at their total market weights. As

far as I can tell, theres no good reason to believe that thats true. Its probably not important.)

The CAL for the Market Portfolio is called the Capital Market Line (CML), illustrated here,

along with a few other CALs (so you can see that the CML has the highest Sharpe ratio (slope)),

the efficient frontier, and the optimal frontier:

so the slope of the CML the Sharpe ratio for the Market Portfolio is:

The security market line (SML) is derived from the CML; the only difference is that the

horizontal axis for the SML is systematic risk beta () whereas the horizontal axis for the

CML is total risk standard deviation () of returns:

One of the assumptions of MPT is that securities are fairly priced. If a security is fairly priced

then it is generating returns that are appropriate for the risk that it poses: it will plot on the CML

(expected return vs. of returns (total risk)), and it will plot on the SML (expected return vs.

(systematic risk)).

If a security plots above the CML or above the SML, then it is generating returns that are too

high for the risk it poses: the security is underpriced. (For example, suppose that a security is

priced at $10 and is earning a 10% return ($1.00) when, according to its risk it should be earning

a 5% return. A return of $1.00 is 5% of $20, so the security should be priced at $20: it is

underpriced.)

If a security plots below the CML or below the SML, then it is generating returns that are too low

for the risk it poses: the security is overpriced.

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