The capital asset pricing model (or CAPM) is among the most widely-used asset pricing models by stock analysts and portfolio managers. Its popularity arises from its simplicity and elegance. Analysts can use it to forecast returns or to estimate the cost of equity. In this post, we offer a CAPM calculator and discuss the model and its assumptions.
You need the following inputs to use the CAPM calculator:
- The beta of the asset. This can be estimated based on historical returns.
- The risk-free rate of return. This is often proxied by yields on government bonds.
- Expected return on the market portfolio. Historical returns on a market index such as S&P500 can be a starting point, with the analyst adjusting this based on his beliefs about future performance.
CAPM equation can be stated as follows:
This equation suggests that a stock’s (or any risky asset’s) expected return E[Ri] depends on its beta βi, the riskless rate of return Rf, and the market’s expected return E[Rm]. More specifically, it states that:
Expected return = Risk-free rate + Risk premium
where the risk premium βi (E[Rm] − Rf) is higher for stocks with higher betas. This is because beta is a measure of systematic risk, and high-beta stocks bear more systematic risk compared to low-beta ones.
It is worth noting that the CAPM equation applies to portfolios of assets (think of investment funds) as well as individual assets.
We can list the CAPM assumptions as follows:
- Investors act rationally and are mean-variance optimizers.
- They are assumed to agree on the expected return and variance of each asset and covariances between asset pairs. This means that they will all end up with the same optimal risky portfolio when they engage in mean-variance optimization.
- They have a single investment period (e.g., a year) in mind.
- All assets are tradeable and perfectly divisible.
- Investors are price takers (i.e., their trades do not influence prices).
- They can lend or borrow unlimited amounts at a common risk-free rate.
- Short selling is allowed without limits.
- There are no taxes and transaction costs (e.g., trading commissions).
Note that these are the assumptions for the standard version of the model. Extended versions of the model relax some of these assumptions. For example, one of the extensions allows for differential rates for borrowing and lending.
In this lesson, we have discussed the capital asset pricing model and have provided a CAPM calculator. The model concerns itself with the pricing of risky assets in market equilibrium. It posits that if all investors engage in mean-variance optimization in the spirit of modern portfolio theory, the optimal risky portfolio becomes the market portfolio. And, because idiosyncratic risk is diversified away within the market portfolio, investors require a risk premium on market risk only, which is captured by beta. As a result, CAPM predicts a linear relationship between an asset’s expected return and its beta.
Sharpe (1964) ‘Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk‘, The Journal of Finance, Vol. 19 (3), 425-442.
what is next?
If you’ve enjoyed reading this post, we’d recommend you check our investments course, which is accessible for free.
- Next lesson: We will focus on the security market line, which is a visual illustration of the CAPM equation.
- Previous lesson: We explained the distinction between systematic risk and idiosyncratic risk.
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