Capital Asset Pricing Model
1. What is CAPM (Capital Asset Pricing Model)?
The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between risk and expected return. It helps investors determine if a stock or investment is fairly priced, undervalued, or overvalued based on the amount of risk it carries.
For example: If two stocks have different levels of risk, CAPM helps you calculate how much more return you should demand from the riskier one.
CAPM assumes that investors should be rewarded in two ways:
- ✅ Time value of money (through the risk-free rate)
- ✅ Risk premium (for taking on extra risk beyond the safe return)
2. CAPM Formula (Equation)
The formula for CAPM is:
Re=Rf+βi(ERm−Rf)
Let’s break this down:
| Term | Meaning |
|---|---|
| Re | Expected return of the asset |
| Rf | Risk-free rate (e.g., return on government bonds) |
| β (Beta) | How volatile or risky the asset is compared to the market |
| Rm | Expected return of the entire market |
| (Rm − Rf) | Market Risk Premium — the extra return expected from the market |
💡 Why this formula matters:
It tells you how much return you should expect for a given risk. If the actual return is higher than the CAPM result, the stock may be a good deal. If it’s lower, it may be overpriced.
3. Security Market Line (SML)
The Security Market Line (SML) is a graphical representation of the CAPM formula.
📊 Axes:
- X-axis: Beta (systematic risk)
- Y-axis: Expected return
💡 What it shows:
- All correctly priced assets should lie on the SML.
- If an asset lies above the SML → it’s undervalued (offers higher return for its risk).
- If it lies below the SML → it’s overvalued (offers less return for its risk).
4. Capital Market Line (CML)
The Capital Market Line is used to represent the risk-return tradeoff for efficient portfolios, using both:
- A risk-free asset (like treasury bonds)
- The market portfolio (a diversified set of assets)
📊 Axes:
- X-axis: Standard deviation (total risk)
- Y-axis: Expected return
📌 Key Differences (CML vs. SML):
| Feature | CML (Capital Market Line) | SML (Security Market Line) |
|---|---|---|
| X-axis | Standard deviation | Beta |
| Risk Type | Total risk | Systematic risk |
| Assets Represented | Only efficient portfolios | All individual risky assets |
| Includes Risk-Free? | Yes | Yes |
5. Assumptions of CAPM
CAPM is based on several assumptions. These simplify the real world so the model can work mathematically.
✔️ Key Assumptions:
- Investors are rational and risk-averse
- They prefer more return with less risk.
- Markets are efficient
- Prices reflect all available and relevant information instantly.
- Risk-free asset exists
- Investors can lend/borrow money at a risk-free rate (like govt bonds).
- All investors have the same expectations
- Everyone evaluates risk and return the same way.
- No taxes or transaction costs
- Buying/selling doesn’t cost anything extra.
- All investors can diversify perfectly
- They can create optimal portfolios with no unsystematic risk.
- Returns follow a normal distribution
- Returns are symmetric, like a bell curve.
⚠️ Why these matter:
These assumptions make the model neat, but they’re not always true in the real world. That’s why CAPM is often combined with more complex models.
6. Uses of CAPM
CAPM is very practical in modern finance.
| Use Case | How It Helps |
|---|---|
| ✅ Portfolio management | Helps choose stocks based on risk/return |
| ✅ Stock valuation | Compare actual vs. expected return |
| ✅ Corporate finance | Estimate cost of equity for capital budgeting |
| ✅ Investor analysis | Know if they’re being rewarded for risk |
| ✅ Risk-based pricing | Decide required return on risky projects |
7. Limitations of CAPM
While helpful, CAPM has some limitations:
- Too many unrealistic assumptions
- No taxes, no transaction costs, perfect markets — all are idealistic.
- Beta may be unstable
- Historical beta doesn’t always predict future risk.
- Ignores other risk factors
- Like liquidity, industry-specific risks, inflation, etc.
- One-Factor Model
- CAPM only uses market risk. More modern models (like Fama-French) add size, value, momentum, etc.
8. CAPM vs. Other Models
| Model | Factors Used | Complexity | Realism |
|---|---|---|---|
| CAPM | Market risk (beta) only | Simple | Moderate |
| Fama-French Model | Market risk, size, value | Higher | More realistic |
| APT (Arbitrage Pricing) | Multiple macroeconomic risks | Complex | Very realistic |
Conclusion
CAPM is one of the most important financial models. If you’re into investing, financial modeling, or corporate finance, understanding CAPM is a must. It gives you a logical way to evaluate investments, decide if you’re being paid enough for the risk, and choose efficient portfolios.
