CAPITAL ASSET PRICING MODEL

Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

Introduction

The capital asset pricing model, developed by WilliamF. Sharpe and John Lintner in the middle 1960s, is the theoretical relationship between the required rate of return on an investment and the investment's risk (Bernstein, 1992, pp: 22).

The required rate of return on an investment is the rate of return that investors require to compensate them for the risk of undertaking the investment. For example, investing in one-year Treasury Bills is a very safe investment. In modern times the U.S. Treasury has never defaulted on an interest or principal payment, and investment in U.S. Treasury instruments is for all intents and purposes risk free. But because there is very little risk, the rate of return is also very low: Currently, one-year Treasury Bill rates are on the order of 1.5% to 2.0%. In contrast, investing in common stock is very risky, and investors expect rates of return in excess of 10% per year to compensate them for bearing this risk (Bernstein, 1992, pp: 27).

Discussion and Analysis

The Capital Asset Pricing Model (CAPM) decomposes a portfolio's risk into systematic and specific risk. Systematic risk is the risk of retaining the market portfolio. As the market moves, each individual asset is more or less affected. To the span that any asset participates in such general market moves, that asset entails systematic risk. Specific risk is the risk which is exclusive to an individual asset. It represents the constituent of an asset's return which is uncorrelated with general market moves. The capital asset charge model identifies that the expected (or required) rate of return, ERS , on an investment in security S is identical to:

Where Rf is the risk-free rate, ER M is the anticipated rate of come back on the market portfolio, and ßS is the security's beta.

Of the three variables on the right-hand side of the equation, only the risk-free rate is easy to estimate. Practitioners use the yield on a long-term (20 to 30 years) Treasury bond as the risk-free rate. This rate can be found in the Wall Street Journal and in a variety of online sources (Brigham, 2002, pp: 161).

The key component of the form is that it separates the risk affecting an asset's come back into two categories. The first type is called unsystematic, or company-specific, risk. The long-term mean returns for this kind of risk should be zero. The second kind of risk, called systematic risk, is due to general financial uncertainty. The CAPM states that the come back on assets should, on mean, identical the yield on a risk-free bond held over that time in addition to a premium proportional to the allowance of methodical risk the stock possesses.

According to CAPM, the marketplace reimburses investors for taking systematic risk but not for taking specific risk. This is because exact risk can be diversified away. When an investor retains the market portfolio, each one-by-one asset in that portfolio entails exact risk, but through diversification, the investor's net ...