Capital asset pricing model?

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The Security Market Line, seen here in a graph, describes a relation between the beta and the asset's expected rate of return.

The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a number often referred to as beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.

The model was introduced by William Sharpe, John Lintner and Jan Mossin independently. Sharpe received the Nobel Memorial Prize in Economics (jointly with Harry Markowitz and Merton Miller) for his contribution to the field of financial economics.

The formula

According to the CAPM, the relation between a given asset i, and a proxy portfolio m (here, the market portfolio) is described as:

Where:

• E(r_i) is the expected return on the capital asset
• r_f is the risk-free rate of interest
• β_im (the beta) the sensitivity of the asset returns to market returns, or also,
• E(r_m) is the expected return of the market
• (E(r_m) − r_f) is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return).

For the full derivation see Modern portfolio theory.

Asset pricing

Once the expected return, E(r_i), is calculated using CAPM, the future cash flows of the asset can be discounted to their present value using this rate to establish the correct price for the asset.

In theory, therefore, an asset is correctly priced when its observed price is the same as its value calculated using the CAPM derived discount rate. If the observed price is higher than the valuation, then the asset is overvalued (and undervalued for a too low price).

Alternatively, one can "solve for discount rate" for the observed price given a particular valuation model and compare that discount rate with the CAPM rate. If the discount rate in the model was lower than the CAPM rate then the asset is overvalued (and undervalued for a too high discount rate).

Asset specific required return

The CAPM returns the asset appropriate required return or discount rate - i.e. the rate at which future cash flows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one signify more than average "riskiness"; betas below one indicate lower than average. Thus a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. The CAPM is consistent with intuition - investors (should) require a higher return for holding a more risky asset.

Since beta reflects asset specific sensitivity to non-diversifiable, i.e. market, risk, the market as a whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for the market - and in that case (by definition) have a beta of one. An investor in a large, diversified portfolio (such as a mutual fund) therefore expects performance in line with the market.

Risk and diversification

The risk of a portfolio is comprised of systematic risk and specific risk. Systematic risk refers to the risk common to all securities - i.e. market risk. Specific risk is the risk associated with individual assets. Specific risk can be diversified away (specific risks "average out"); systematic risk (within one market) cannot. Dependent on market, a portfolio of approximately 15 well selected shares (and more) would be sufficiently diversified to leave the portfolio exposed to systematic risk only.

An investor cannot expect to be rewarded for taking on diversifiable risk, (it is not rational to expose one's wealth to more risk than necessary). Therefore, the required return on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e. its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is represented by higher variance i.e. less predictability.

The efficient (Markowitz) frontier

Efficient Frontier

The CAPM assumes that the risk-return profile of a portfolio can be optimized - an optimal portfolio displays the lowest possible level of risk for its level of return. Additionally, since each additional asset introduced into a portfolio further diversifies the portfolio, the optimal portfolio must comprise every asset, (assuming no trading costs) with each asset value-weighted to achieve the above (assuming that any asset is infinitely divisible). All such optimal portfolios, i.e., one for each level of return, comprise the efficient (Markowitz) frontier.

The market portfolio

An investor might choose to invest a proportion of his wealth in a portfolio of risky assets with the remainder in cash - earning interest at the risk free rate (or indeed may borrow money to fund her purchase of risky assets in which case there is a negative cash weighting). Here, the ratio of risky assets to risk free asset determines overall return - this relationship is clearly linear. It is thus possible to achieve a particular return in one of two ways:

1. By investing all of one’s wealth in a risky portfolio,
2. or by investing a proportion in a risky portfolio and the remainder in cash (either borrowed or invested).

For a given level of return, however, only one of these portfolios will be optimal (in the sense of lowest risk). Since the risk free asset is, by definition, uncorrelated with any other asset, option 2) will generally have the lower variance and hence be the more efficient of the two.

This relationship also holds for portfolios along the efficient frontier: a higher return portfolio plus cash is more efficient than a lower return portfolio alone for that lower level of return. For a given risk free rate, there is only one optimal portfolio which can be combined with cash to achieve the lowest level of risk for any possible return. This is the market portfolio.

Assumptions of CAPM

• All investors have rational expectations.
• All investors are risk averse.
• There are no arbitrage opportunities.
• Returns are distributed normally.
• Fixed quantity of assets.
• Perfect capital markets.
• Seperation of financial and production sectors.
  • Thus, production plans are fixed.
• Risk-free rates exist with limitless borrowing capacity and universal access.

Shortcomings of CAPM

• The model does not appear to adequately explain the variation in stock returns. Empirical studies realized in the past 15 years show that low beta stocks may offer higher returns than the model would predict. (See Good and bad betas for a response.)
• The model assumes that investors demand higher returns in exchange for higher risk. It does not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well.
• The model assumes that all investors agree about the risk and expected return of all assets.
• The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed with more complicated versions of the model.
• The model assumes that asset returns are lognormally distributed, random variables. There is significant evidence that equity and other markets are complex, chaotic systems. As a result, large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect. These swings can greatly impact an asset's value.
• The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitalization. This assumes no preference between markets and assets for individual investors, and that investors choose assets solely as a function of their risk-return profile. It also assumes that all assets are infinitely divisible as to the amount which may be held or transacted.
• The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capitalw/.) In practice, such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM, and it has been said that due to the inobservability of the true market portfolio, the CAPM might not be empirically testable.

Finding related topics

• Valuation
• Modern portfolio theory
• Arbitrage Pricing Theory (APT)
• Efficient market hypothesis

References

• Fama, E. and French, K. (1992). The Cross-Section of Expected Stock Returns, Journal of Finance, June 1992, 427-466.
• Black, F., Jensen, M., and Scholes, M. The Capital Asset Pricing Model: Some Empirical Tests, in M. Jensen ed., Studies in the Theory of Capital Markets. (1972).
• Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets, Review of Economics and Statistics, 47
• Markowitz, Harry M. (1999). The early history of portfolio theory: 1600-1960, Financial Analysts Journal, 55 (4)
• Mossin, Jan. (1966). “Equilibrium in a Capital Asset Market,” Econometrica, 34, 768-783.
• Ross, Stephen A. (1977). The Capital Asset Pricing Model (CAPM), Short-sale Restrictions and Related Issues, Journal of Finance, 32 (177)
• Sharpe, William F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk, Journal of Finance, 19 (3), 425-442
• Tobin, James (1958). Liquidity preference as behavior towards risk, The Review of Economic Studies, 25

External links

• Articles
  • Article on CAPM
  • The efficient frontier

• Efficient frontier generators
  • two asset efficient frontier
  • multiasset efficient frontier

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