Capital asset pricing model or CAPM is a specialised model used in business finance to determine the relationship between the expected dividends and the risk associated with investing in particular equity. When assessing CAPM, one can understand that expected returns on specific security are equal to the risk-free returns plus the addition of a beta factor.
Assessing the capital asset pricing model requires a proper understanding of systematic and unsystematic risks. Systematic risks are general dangers, which are associated with the investment of any form. Wars, inflation rate, recessions, etc. are some of the examples of systematic risks.
Unsystematic risks, on the other hand, refer to specific perils associated with investing in a particular stock or equity. Thus, unsystematic risks are not perceived as threats, which are shared by the general market.
CAPM deals mostly with systematic risks on securities, thereby predicting whether things can go wrong with particular investments.
Formula for CAPM
CAPM formula is given by –
Ra = Rf + Be x (Rm – Rf)
The different factors of this equation are –
- Ra = Expected dividend from investment
- Rf = Risk-free rate
- Be = Beta factor of the underlying transaction
- (Rm – Rf) = Current market risk premium
This entire formula considers the returns, which an investor is liable to receive due to their risk-taking ability and extended time of investment. The beta factor is determined as a risk in conjunction with current market conditions.
Therefore, if the risk associated with an investment is lower than the present conditions, the beta value will be less than 1. For risk equalling that of market conditions, a beta of this equation will always be equal to 1. Lastly, if the risk exceeds that of the established market norm, ‘Be’ value in the formula will be greater than 1.
Example of CAPM
A CAPM example can assist in evaluating how this formula works. Consider the following when trying to understand the various factors in CAPM calculation.
An investor is considering buying stocks priced at Rs. 367, which offer annual returns of 4%. Assuming that a beta factor of 1.1 is associated with this particular stock, one can calculate the expected dividend earnings by considering the risk-free premium as 3% and investor expectation of market appreciation by 7% annually.
Arranging the various factors into the formula, one can arrive at the following conclusion –
Ra = 4% + 1.1 x (7% – 3%)
Ra = 8.4%
Consider another example of the CAPM model. In this next one, the investor is all set to buy stocks worth Rs. 455. Annual returns from such an investment are expected to be around 9%. Beta factor, in this case, is 0.8. Risk-free rate is 5%. This investor expects the market to increase in value by 8% within this next year.
Ra = 9% + 0.8 x (8% – 5%)
Ra = 11.4%
Role of Beta in CAPM
Beta is an integral factor in CAPM. It reflects the volatility of given security against the volatility of the stock market as a whole. For better understanding, consider that a share’s price appreciates and depreciates in total sync with the market. In such a case, the beta factor would be one.
However, if the beta of a stock is 1.2, it is indicative of the stock prices rising by 12% when the market appreciates by 10%. Similarly, a negative beta (say of 0.7) indicates that the stock prices will rise by 7% when the market collectively grows by 10%.
The summation of beta and the risk premium of an investment is necessary when determining the amount of compensation a particular investor is liable to receive for taking this additional risk.
How does CAPM Benefit Investors?
Listed below are some of the advantages of this model of risk-reward evaluation for investors –
- Assumption of a diversified portfolio
This model assumes that an investor maintains a diversified investment portfolio, which can eliminate specific or unsystematic risks.
- Convenient and simple
This model is built around the fact that it is extremely easy to use. The results from such a calculation are dependable and enable investors to decide one way or another when it comes to choosing particular equities.
- Systematic risks can alter this calculation significantly
A beta factor in the capital asset pricing model considers any systematic risks associated with one’s investment. Dividend discount model or DDM, which is another popular return predicting model, disregards the effects of such risks on returns. Since market risk is unforeseen and unpredictable, no investor can mitigate its effects in their entirety.
Drawbacks of CAPM
While CAPM is a dependable calculation model, followed by investors worldwide, it does present some drawbacks as well –
- Risk-free rates tend to change frequently
Short-term government securities are responsible for generating the risk-free premium or rate used in CAPM calculations. A major problem of this model is that this risk-free rate is highly volatile, altering within a span of just a few days.
- Risk-free rate is not a realistic factor
Individual investors cannot borrow or lend at the same rates as the government. Therefore, assuming a risk-free rate for calculation is not realistic. Thus, the actual return from an investment may be lower than what this CAPM model reveals.
- Determining a beta can be challenging
Investors using this model of return calculation need to figure out a beta value, which reflects the security in question. Unfortunately, evaluating an accurate beta can be time-consuming and difficult. Therefore, in most cases, a proxy beta value is utilised. This ultimately accelerates return calculations but also diminishes its accuracy.
A capital asset pricing model suffers from similar problems when compared to other scientific models. It still provides an accurate overview of the kind of dividends that investors can expect when they park their funds by incurring some risk.