Understanding the Concept of CAPM
Capital Asset Pricing Model and Required Rate of Return
Nearly every asset class has an element of risk. Learn how to evaluate investments based on the Capital Asset Pricing Model (CAPM).
Analysts use Capital Asset Pricing Model (CAPM) to evaluate, from the theoretical point of view, an asset’s expected rate of return, provided that the asset is part of a well-diversified portfolio and provided that the asset’s portion of risk that cannot be diversified away has been taken into account. Agreed, this is a rather complex definition, but let’s see if it can be broken down into more “chewable” components.
Simply said, or at least attempting to say it simply, the CAPM model claims that an investor’s expected rate of return is the rate of return of a risk-free asset plus the market risk premium correlated to the measurement of market risk or its beta. So, if the investor’s expected rate of return on an asset falls short of that asset’s required rate of return, the investor will not have a justifiable reason to invest his or her money in the asset.
Dissecting the CAPM Formula
But what is a risk-free asset and what is the market risk premium? The risk-free asset is an asset that provides a specific risk-free return, it has a variance of zero, and it is uncorrelated to risky assets. As far as the rest of the formula is concerned, an asset’s market risk is best evaluated with its beta, while the market risk premium is defined as a reward for bearing non-diversifiable risk, and it is calculated by subtracting the risk-free asset’s return from the required rate of return on a risky asset.
The formula for calculating the expected rate of return according to the CAPM model is linear in nature, as demonstrated below:
E(Ri) = Rf + ßi(Rm – Rf); whereby E(Ri) is the expected rate of return on an investment, Rf is the rate of return on risk-free asset, ßi is an investment's beta, and (Rm – Rf) is the market risk premium;
Systematic and Unsystematic Risk
In essence, the CAPM model dissects a portfolio’s total risk into two components: systematic risk and unsystematic risk, (the latter is also referred to as specific risk or diversifiable risk). Whenever the market moves either up or down, each individual asset is impacted by its movements to some degree.
The degree to which the market impacts individual assets is called the systematic risk. This is also the type of risk that cannot be diversified away. On the other hand, unsystematic risk is the type of risk that is unique to a specific asset, it is generally uncorrelated to the general market, and it can be diversified away, but only to an extent.
Obviously, it is impossible to completely eliminate risk. However, as the CAPM model assumes, through careful diversification, the risk can at least be minimized. In other words, if an investor has diversified his or her portfolio well enough and broadly enough, well-performing assets will cancel out poorly performing assets, thus diversifying away as much risk as possible.
If the exercise has been done properly, the residual risk will be the systematic risk only, for which investors will receive at least the risk premium. Of course, if an investor does not want assume any risk at all, he or she may be better off investing only in risk-free assets.
Investors buying shares of publicly listed companies generally require rates of return that are higher than the rates of return offered by risk-free assets. This higher rate of return is really a way of compensating investors for taking on the systematic risk. In addition, investors cannot demand a premium for unsystematic risk. This one is easy to explain: this is because unsystematic risk can be diversified away. Finally, since systematic risk differs from one asset class to another, investors are likely to require higher rates of return for asset classes with higher systematic risk.
Please note that our discussion of the CAPM model is continued in the article CAPM Assumptions and Limitations.
(Source: Investment Analysis and Portfolio Management, Eighth Edition, by Frank K. Reilly and Keith C. Brown, 2005)
