Capital Asset Pricing Model Essay

The capital asset pricing model (CAPM) is an important model in finance theory. CAPM is a theory or model use to calculate the risk and expected return rate of an investment portfolio (normally refer to stocks or shares). All stocks have 2 risks: Systematic Risk (also called Market Risk which affect every stocks) and Unsystematic Risk (also called Specific or Unique Risk that only affects individual stocks). To diversify unsystematic risk, we selected and combined different stocks, which are negatively correlated with one another into one portfolio. In this way risk are eliminated greatly. See diagram below. CAPM Equation The general formula used for Capital Asset Pricing Model is: re = rf + [ ß (rm – rf) ] where the components are as follows: re = Expected return rate of the investment portfolio rf = Risk free rate of return ß = Beta (correlation between the shares and the market) rm = Expected market return which also means: rm – rf = Market risk (systematic risk) ß (rm – rf) = Risk premium *Beta is overall risk value for investing in the stock market. The higher the beta, the more the risk. CAPM Example Assume there is two Investment portfolio (stocks) or project – A & B. With the information given below, we can use CAPM to help us decide which to invest on. risk free rate beta expected market return A 3% 2.5 10% B 3% 1.2 10% From the beta value above, we know A is a more risky portfolio. A is 2.5 times more risky than the overall market and B is 1.5 times less risky. †¢ Expected return produce by A re = rf + [ ß (rm – rf) ] re = 3 + [ 2.5 (10 – 3) ] = 20.5 % †¢ Expected return produce by B re = rf + [ ß (rm – rf) ] = 3 + [ 1.2 (10 – 3) ] = 11.4 % Using CAPM formula, we calculated A produce a 20.5% expected return rate. It is higher than the overall market expected return, which is 10%. Whereas for B, the expected return rate are only 11.2% compare to market return of 10%. Base on result, A is definitely a better but if you don’t feel conformable with A’s risk or think it might not able to produce the expected return rate, then you would probably can choose investing in B. Criticisms of CAPM Although CAPM seems to be one of the most widely used methods to determine the expected return of a investment portfolio, It still have its limitation. Many had criticized on its unrealistic assumptions. †¢ Required a well-diversified portfolio Firstly CAPM works really well with a well-diversified portfolio as it accounted for systematic risk (market risk) but as seen on the graph on page 1, systematic risk is still undiversified. Therefore unsystematic risk is ignore in CAPM calculation. †¢ Beta as it main calculation components As Beta value are computed base on past one year figures so in this case CAPM assume that the future won’t change. Also beta may not really reflect the actual performance of different stocks. This was question by professors Eugene Fama and Kenneth French where they looked at share returns on the New York Stock Exchange, the American Stock Exchange and Nasdaq between 1963 and 1990, they found that differences in betas over that lengthy period did not explain the performance of different stocks. The linear relationship between beta and individual stock returns also breaks down over shorter periods of time. These findings seem to suggest that CAPM may be wrong. †¢ Risk free rate of return CAPM assumes there is a risk free rate where investors can borrow or lend at this rate but it is not true in the real world. †¢ Perfect capital market exists There is no transaction cost for trading in the market and profit is non-taxable. †¢ All investor are the same CAPM assume all investors have the same expectations on the risk and expected return.