What is a capital asset pricing model?

The capital asset pricing model (CAPM) is a formula used in investing to calculate risk and apply it to an expected return on an asset. CAPM can be used to construct a diversified portfolio to reduce risk. 

There are two types of risk: systematic risk refers to overall market risk; unsystematic risk refers to the risk of an individual asset. Unsystematic risk is reduced by asset allocation. 

Where have you heard about a capital asset pricing model?

The concept of the CAPM capital asset pricing model was developed in the 1960s as part of modern portfolio theory to guide investors in the construction of their portfolios. In the 1970s, a CAPM variation, referred to as Black CAPM or zero-beta CAPM, was developed and helped to popularise the concept as it does not make the assumption of a risk-free asset. 

You might have seen the capital asset pricing model explained in the context of an investor hedging their portfolio to fit their risk tolerance. Aggressive investors who tolerate higher levels of risk invest in assets with a higher risk-to-reward ratio, while more conservative investors with a lower risk tolerance select less volatile assets. 

What do you need to know about a capital asset pricing model?

Learning how to calculate a capital asset pricing model can help you to estimate the expected return from an investment and allows you to diversify your portfolio to include different assets with different levels of risk.

The capital asset pricing model formula is as follows:

This can be expressed as expected return = risk-free rate + beta x market risk premium.

The risk-free rate (Rf or Rrf) typically refers to the yield on a 10-year government bond. Beta is a measure of a stock’s volatility relative to the overall market. The risk-free rate subtracted from the expected market return (Rm) calculates the risk premium, which is higher for riskier assets. 

The relationship between the risk and the expected return is the security market line (SML). Investors can use the SML to determine the risk of their portfolio holdings.

To use an example of a stock that has a share price of $100, pays a 3 per cent annual dividend and has a beta of 1.3, assuming the risk-free rate is 3 per cent and the market is expected to rise by 5 per cent annually, the CAPM rate of return is 5.6 per cent:

5.6 per cent = 3 per cent + 1.3 x (5 per cent - 3 per cent)

The expected rate of return can be used to discount the anticipated dividend payout and rise in the share price and calculate the discounted cash flow (DCF). In this case, if the discounted value of future cash flows is below $100 then the CAPM indicates the stock is overvalued, and if it is above $100 it suggests the stock is undervalued.

You should be aware that the capital asset pricing model has its limitations. It is calculated based on past returns, which do not necessarily indicate the future performance of the asset. The formula assumes that the risk-free rate and beta remain constant over time and do not cover all the risks of an asset. It also makes the unrealistic assumption that the investor can borrow and lend funds at the risk-free rate, as individual investors are not able to obtain the same rate as the government.