CAPM
The Capital Asset Pricing Model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a number often referred to as beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical sensitivity of the asset returns to market returns,
- <math>E(r_m)<math> is the expected return of the market, and
- <math>r_f<math> is the cash flows of the asset can be discounted to their present value using this rate to establish the correct price for the asset.
In theory, therefore, an asset is correctly priced when its observed price is the same as its value calculated using the CAPM derived discount rate. If the observed price is higher than the valuation, then the asset is overvalued (and undervalued for a too low price).
Alternatively, one can "solve for discount rate" for the observed price given a particular valuation model and compare that discount rate with the CAPM rate. If the discount rate in the model was lower than the CAPM rate then the asset is overvalued (and undervalued for a too high discount rate).
Asset specific required return
The CAPM returns the asset appropriate required return or discount rate - i.e. the rate at which future cash flows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one signify more than average "riskiness"; betas below one indicate lower than average. Thus a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. The CAPM is consistent with intuition - investors (should) require a higher return for holding a more risky asset.
Since beta reflects asset specific sensitivity to non-diversifiable, i.e. market, risk, the market as a whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for the market - and in that case (by definition) have a beta of one. An investor in a large, diversisifed portfolio (such as a mutual fund) therefore expects performance in line with the market.
Shortcomings of CAPM
- The model does not appear to adequately explain the variation in stock returns. Empirical studies done in the past 15 years show that low beta stocks may offer higher returns.
- What is the Market portfolio? Does it include the bond market? Real estate? Commodities? Private placements?
- The Market portfolio, and hence its return, are not observable and have to be estimated.
- The model assumes that all investors are risk averse. Some investors (e.g., some day traders), are not risk averse.
- The model assumes that all investors create mean-variance optimized portfolios. In fact, there are many investors who don't know what a mean-variance optimized portfolio is.
See also
References
CAPM was introduced by William Sharpe, Lintner and Mossin independently, though it is commonly attributed only to the first of them, who published it earliest (in 1964). Sharpe received The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel (jointly with Harry Markowitz and Merton Miller) for his contribution to the field of financial economics.
- Sharpe, William F. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk, Journal of Finance, 19 (3)
- Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital budgets, Review of Economics and Statistics, 47
- Markowitz, Harry M. (1999). The early history of portfolio theory: 1600-1960, Financial Analysts Journal, 55 (4)
