My retirement is approaching, and I am worried about investment plans apart from the risks. Anyways I can calculate return on each investment by ‘CAPM formula’. For example, I would like to calculate return on Apple Inc., Berkshire and Microsoft. If you are preparing for FRM-I exam you must be aware of CAPM.
CAPM in brief:-
CAPITAL ASSET PRICING MODEL (CAPM)
Some of you, who have traded in securities, mainly equities must have heard a number of times that a share is “under-priced” or “overpriced”. This under or overpricing must have been with respect to “something”. This is nothing but the fair value or intrinsic value of the equity. This fair price is the price at which an investor earns an expected return proportionate to the risk the equity inherently possesses. For example, if there is a US government bond or a sovereign bond which is assumed to be risk free, is expected to give lower returns, as compared to a risky security of any corporate.
If you want to know, how much return you should get in order to be adequately compensated for the risk assumed by investing in a risky security, then CAPM comes to the forefront. CAPM is one of those model which tries to price the inherent risk in equity.
The genesis of the model rests on the fundamentals that any investment comprises two types of risks:
- Systematic Risk: These are the market risks which cannot be diversified away. Interest rates, recession etc. are examples of systematic risk.
- Unsystematic Risk: These are specific to individual stocks and can be diversified away by including more number of stocks in your portfolio.
It simply states that accepting certain assumptions, the expected return from an asset can be calculated.
- Where Rf is the risk free rate, Rm- Rf: Risk Premium
- β: Quantity of Risk
The expected return of a security depends upon two variables i.e. the risk free rate of interest and the risk of the stock itself i.e. beta of the stock. Beta is the measure of risk involved with investing in a particular stock relative to the risk of the market. As per CAPM Beta is the only relevant measure of a stock’s risk.
CAPM vs Arbitrage Theory
The Arbitrage pricing theory is viewed as an alternative to CAPM, since APT has more flexible assumption requirements. But at the same time it is comparatively more difficult to apply because determining which factors influence a stock or portfolio takes a considerable amount of research. It is ideally impossible to detect every factor/variable that affects the security.
The arbitrage pricing attempts to explain the expected return on a stock in terms of other factors. APT differs from CAPM in that it assumes that a stock’s return depends on multiple factors as explained by the APT formula below:
Expected Return = rf + b1 x (factor 1) + b2 x (factor 2)... + bn x (factor n) where
- b = the sensitivity of the stock to each factor
- factor = the risk premium associated with each variable
The CAPM is nothing but a simplified version of the APT, whereby the only factor considered is the risk of a particular stock relative to the rest of the market, as described by the stock's beta.
From a practical viewpoint, CAPM, till today remains the dominant pricing model employed by finance professionals’ .If we were to compare CAPM to the Arbitrage Pricing Theory; the Capital Asset Pricing Model is undeniably elegant and relatively simple to calculate.