Capital Asset Pricing Model (Capm)
Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) is a theoretical framework that attempts to explain the relationship between risk and return for long-term investments. It is a key concept in modern portfolio theory and is widely used by financial professionals to estimate the required return for an investment asset.
Key Assumptions of CAPM:
- Random walk theory: Assumes that asset returns are random and independent of previous returns.
- Efficient market hypothesis (EMH): Assumes that all available information about an asset is already reflected in its price.
- No-arbitrage condition: Assumes that there are no opportunities to arbitrage (take advantage of price discrepancies).
- Risk-free rate: Assumes the existence of a risk-free asset with a known return.
- Beta: Assumes that the asset’s beta (sensitivity to market movements) is a reliable measure of its risk.
Formula for CAPM Return:
r = rF + ฮฒ(rM - rF)
where:
- r: Expected return on the asset
- rF: Risk-free rate of return
- ฮฒ: Asset’s beta
- (rM – rF): Market risk premium
CAPM Implications:
- Higher risk assets have higher expected returns: Assets with higher beta coefficients are expected to have higher returns.
- Risk-free rate and market risk: The risk-free rate and market risk premium are key factors in determining asset returns.
- Portfolio diversification: Diversification across assets with different betas can reduce overall portfolio risk.
- Systematic risk: CAPM cannot explain random fluctuations in asset returns, only systematic risk.
Criticisms of CAPM:
- Data dependence: CAPM relies on historical data to estimate beta and expected returns, which can be unreliable.
- Lack of theoretical foundation: CAPM lacks a solid theoretical foundation and some aspects are ad hoc.
- Market efficiency assumptions: CAPM assumes that markets are efficient, which may not always be true.
Overall, CAPM is a powerful tool for understanding the relationship between risk and return. However, it has limitations and should not be used in isolation.