Capital Asset Pricing Model (CAMP)

 

Who & when developed this model –

The CAPM model was given by 3 Economist in 1960.

1.      William F. Sharpe (1964) – Most of credit goes to William F. Sharpe for developing CAPM model, He later awarded by the Nobel Prize in Economics (1990) for his work on CAPM.

2.      John Lintner (1965)

3.      Jan Mossin (1966)

They extensive worked on Harry Markowitz’s Modern Portfolio Theory (1952), which clarified diversification and well-organized portfolios, in this model we talk about the linkage of expected return with Risk.

So, the main inventor credited = William Sharpe, but it’s actually a joint development with Lintner and Mossin.

Now Let’s understand What is Capital Asset Pricing Model (CAPM)

CAPM is a financial model by which we calculate the expected return on the equity invested in the market based on the company’s risk in relation with market risk.

The components of CAPM model

1.      Risk free rate – investor should be rewarded with Risk free rate for time value of money

2.      Equity risk premium & Beta - investor should rewarded with equity risk premium for extra risk taken by investing in the particular company’s equity.

 

Capital Asset Pricing Model (CAPM) Formula

E(Ri​)=Rf​+βi​(Rm​−Rf​)

here:

 E(Ri) =it is Expected return on the Equity (investment)

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Understanding Beta (β)

Beta (β) → Measures systematic risk (stock sensitivity to market).

·       β = 1 → same risk as market

·       β > 1 → riskier than market

·       β < 1 → less risky than market

·       β < 0 → moves opposite to market

 

Example

Risk-free rate = 5%

Market return = 12%

Beta of stock = 1.2

E(Ri​)=Rf​+βi​(Rm​−Rf​)

E(Ri​)=6%+1.1(11%-6%)

         = 5% + 5.5% = 10.5%

This means investor should expect 10.5% return from this stock.

Assumptions of CAPM

·       This model is for the Investors who are risk-averse.

·       Unlimited borrowing/lending at risk-free rate.

·       In this model No consideration of taxes, no transaction costs (brokerage).

·       It assumes that all investors have same expectations for market and equity shares.

·       It also assumes that Markets are seamlessly efficient.

·       Returns are normally distributed.

These assumptions are unrealistic but make the model simple.

 

Advantages

·       It is Easy to use, only one simple formula.

·       Generally accepted in valuation, corporate finance, and portfolio theory.

·       It is very useful for calculating cost of equity (important in Weighted average cost of capital, Discounted cash flow method)

·       Connects risk - expected return directly.

 

Disadvantages

·     Impractical assumptions – practically tax we pay, risk free borrowing in not practical. This model doesn’t consider both tax and risk on borrowing.

·       Beta is not steady; it keeps changing over time.

·       Market return estimation depends on person to person.

·       It Doesn’t consider unsystematic risk.

·       Can give misleading results in inefficient markets.

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