Updated: Dec 7, 2021
The Capital Asset Pricing Model (CAPM) is one of the most important models in finance. It is a model that describes the relationship between the risk and the expected return of securities by indicating that the expected return on a security is equal to the risk-free return plus a risk premium.
The expected return can be calculated using the formula:
Expected return = risk free rate of return + beta*(risk premium)
[risk premium = market portfolio return - risk free rate of return]
The risk-free rate of return:
CAPM assumes that there is a risk-free asset with 0 standard deviation
Investors who are risk-averse prefer to purchase risk-free assets to protect their money and earn a low return
An example of a risk-free asset would be a US government ten year Treasury bill because the US government backs it
Market portfolio return:
This includes all the securities in the market.
A good representation of the market would be the S&P500, as it is a market-capitalisation-weighted index of the 500 largest US publicly traded companies.
Beta represents the gradient of the regression line on a 'market return against stock return' graph.
Beta is a measure of the volatility of a security or portfolio compared to the entire market.
Beta = 1 → indicates that its price activity strongly correlates with the market.
Beta < 1 (defensive) → indicated that the security is theoretically less volatile than the market; portfolio/security is less risky than the market
Beta > 1 (aggressive) → indicates that the security's price is more volatile than the market; portfolio/security is riskier than the market.
You can use the CAPM to scale and normalise companies to visualise and calculate beta for individual securities. Knowing this would tell you how volatile the company's stock is compared to the market, which you could then use to make an informed decision to either purchase the stock or not.
Although, the limitation of CAPM is that the Beta coefficient is unstable, varying from period to period depending on the company's method, meaning that it may not reflect the actual risk involved.
If you are interested in the Capital Asset Pricing Model, look out for a future blog post where I will explain how to code this model in Python!
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