The Capital Asset Pricing Model (CAPM) is a model which is used to describe the relationship between the risks and returns for assets such as stocks. Therefore in theoretical terms it enables to assess the required rate of return from a particular asset. It basically helps the investors to analyse and assess the profits they may gain from assets such as securities and whether a particular asset should form a part of their diversified portfolio or should be sold off from their portfolio. Therefore the said model enables the investors to take more informed decision with regards the assets which are very sensitive to the market movement and these risks cannot be diversified also.
Capital Asset Pricing Model (CAPM ) was introduced so as to enable determination of prices of individual stocks and a portfolio as a whole. It was formulated by Jack Treynor in the year 1961 & 1962, William F. Sharpe in the year 1964, John Lintner in the year 1965 and Jan Mossin in the year 1966. Thus it was introduced by four eminent economists separately. One more version of CAPM was developed named Black CAPM by Fischer Black in the year 1972.
lign: justify;">The CAPM is required by a portfolio manager who helps the investors decide about their portfolio. His main work is calculation of the equity capital to a company. Thus the said method enables quantification of the expected perils and thus enabling conversion of the possible risks to expected returns on equity. The theory has various assumptions to be taken into consideration while calculating the expected return from the risks that the securities possess. Firstly it assumes that the financial markets is full of investors who are well informed, highly educated and are prudent buyers and sellers. Second assumption states that the investors are very much concerned about their money and expect to earn a premium for the extra risks they assume while investing(Fama, & French, 2004). Thirdly all the investors are considered to be moving ahead towards the same period for planning their investments. Fourthly there are no taxes or concessions or commissions applicable. Lastly it is assumed that there is just one risk free rate and the investors borrow or lend in that rate only (Mullins, 1982).
The formulae for calculating the return from a asset from the expected risks is :
r* = kRF + b(kM - kRF)
r*= Required rate of return
kRF= Risk free rate
kM= Average market return
b= Beta Coefficient of security (Wogner, 2015)
The said formula is also known as Security Market Line Formula.
The Security Market Line is a line which correlates the return an investment fetches in relation to the risks attached. The measurement used for risk by the SML is beta. The SML diagram below clearly indicates that the line begins with nil risk attached to an investment and as the line is moving diagonally upwards the risk attached to an investment increases with an increase in the risk also. Thus risk and return are directly proportionate to each other. Therefore an investor with a low appetite for risk would prefer investing at the beginning of the SML and those with a higher risk appetite would prefer to invest at the middle or above that of the SML.
The Capital Market Line (CML) is a line which portrays the rate of return of an efficient investment portfolio after taking into account the level of risks attached for a market portfolio and the risk free rate of return. Therefore this line basically speaks about not only the risks attached to a particular stock i.e. unsystematic risks but also how the risks affect the functioning of the overall market i.e. systematic risk. Thus whenever an investor build up his investment portfolio his basic idea lies to gain the maximum possible return with minimum possible risk attached. But the said idea situation does not exist always because of the attached volatility and unexpected performances and movements of the stocks, therefore increased risk can also lead to magnification of losses. Therefore the CML can be described diagrammatically as under:
From the above two definitions it is clear that there exists a relationship between the SML and CML in a Capital Asset Pricing Model. Both the concepts are related to the extend that many a times the SML is said to be a part of the CML while calculating the risks associated with securities. The CML connotes the risk and the return for the entire portfolio of stocks whereas the SML reflects the risk and returns associated with individual securities which form a part of the overall portfolio. The measurement basis of risk is however not same. The CML uses the standard deviation and the SML uses beta. Therefore the capital market line focuses mainly on the performance of the overall portfolio whereas the SML’s focus is narrowed down to only individual securities.
The Capital Asset Pricing Model theory has various advantages and uses that enables the investors to decide upon which securities to buy and how to build up a healthy and a profitable portfolio. They are:
However, the said model has got criticisms also due to some disadvantages attached to it. The same are as follows:
The CAPM model is highly regarded and accepted world-wide, but there are other methods also used to determine the return against the risks attached to investments. Such as the Gordon DDM (Dividend Discount Model), Multi-Beta Models and Market Price Based model. These methods offer better methodologies of measuring risks and returns of the investments.
The second alternative to it is The Multifactor Model which uses the past information of the stocks in question and relates it to the specific macro economic variables and thus assigns beta to the individual companies against these macro economic variables (Krause, 2001).
Thus on a concluding note it is clear that CAPM is a very age old model which investors and the portfolio managers have been relying upon. Yet the same has some advantages and disadvantages to it which cannot be ignored. Being the most tried and stress tested model economists prefer it even though it is based on assumptions which may seem to be unrealistic. As per my recommendation although various other refined models have come up yet the CAPM dominates. According to me a portfolio manager should use Capital Asset Pricing Model and over and above the same he could use other methods as well. The alternate methods are also acceptable but no model is full proof each have their own pluses and minuses which should be considered while analysing a portfolio.
Damodaran, A., (2015), The Dividend Discount Model, Available at https://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/ddm.pdf (Accessed 08th September 2016)
Fama, E.F., & French, K.R., (2004), The capital Asset Pricing Model: Theory and Evidence, Journal of Economic Perspectives, vol. 18, no. 3, pp. 25-46
Jylha, P., (2014), Margin Constraints and the Security Market Line, Imperial College Business School, Available at https://www.cbs.dk/files/cbs.dk/paper_petrijylha.pdf (Accessed 08th September 2016)
Krause, A., (2001), An Overview of Asset Pricing Models, University of Bath School of Management, Available at https://people.bath.ac.uk/mnsak/Research/Asset_pricing.pdf (Accessed 08th September 2016)
Lee, M.C., & Su, L.E., (2014), Capital Market Line Based on Efficient Frontier of Portfolio with Borrowing and Lending Rate, Universal Journal of Accounting and Finance, vol. 2, no.4, pp. 69-76
Mullins, D.W., (1982), Does the Capital Asset Pricing Model Work?, Available at https://hbr.org/1982/01/does-the-capital-asset-pricing-model-work (Accessed 08th September 2016)
Sigman K., (2005), Capital Asset Pricing Model (CAPM), Available at https://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-CAPM.pdf (Accessed 08th September 2016)
Wogner, J., (2015), Capital Asset Pricing Model (CAPM): Definition, formula, Advantages and Example, Available at https://study.com/academy/lesson/capital-asset-pricing-model-capm-definition-formula-advantages-example.html (Accessed 08th September 2016)
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