The CAPM was developed to explain the riskiness of securities priced in the market and this was attributed to experts like Sharpe and Lintner. Markowitz theory being more theoretical, CAPM aims at a more practical approach to stock valuation.
CAPM-Assumptions
The CAPM is based on certain assumptions. These assumptions (few in common with Market Portfolio Theory) are set out below.
- The investor aims at maximising the utility of his/her wealth, rather than the wealth or rerun. The difference between them is that individual preferences are taken into account in the utility concept. While some have the capacity for larger risk and will have increasing marginal, utility for wealth for others with less capacity for risk, the incremental wealth will be less attractive if it is attached with more risk. Thus, the preference of investors for risk return is taken into account in this model.
- Investors have similar expectations of Risk and Return. Without these consensus standards, the estimates of mean and variance may lead to different forecasts with the result that the client portfolio of each will be different from that of the others. There will be innumerable efficient frontiers, each dependent on the set of preferences of individuals for risk and return. If investors do not have similar expectations there will be no homogeneity in their conception and no single efficient frontier line will apply to all.
This in turn will imply that the price of an asset, which is the best estimate of the present value of future returns will be different for different investors.
- Investors make investment decision on a rational basis, depending on their assessment of risk and return. Risk is measured by two factors, mean and variance. In the CAPM it is assumed that rational investors diversify away their diversifiable risk, namely, unsystematic risk and only systematic risk remains which varies with the Beta of the security.
- While some use only the beta as a measure of risk, others use both beta and variance of returns (total Risk) as the sources of reward or expected return. As these perceptions of risk and reward vary from individual to individual, there are a series of efficient frontier lines in CAPM while in the case of MPT, there will be a single efficient frontier line as the conception of risk and return expectation is assumed to be homogeneous in the latter.
- Investors will have free access to all available information at no cost and no loss of time.
- The transactions cost is low enough to ignore and assets can be bought and sold in any unit desired. The investor is limited only by his wealth and the price of the asset.
- Taxes do not affect the buying of assets.
- Investors should have identical time horizons. Investors make their investment decisions based on a single period horizon.
The assumptions above enable managers to be much more precise about how trade-offs between risk and returns are understood in the financial market.
In the CAPM, the expected rate of return is taken as the ‘required rate of return’ because the market is believed to be in equilibrium. The expected return is the return from an asset that investors anticipate over a future period. The required rate of return is the minimum expected rate of return needed to induce an investor to purchase it.
Elements of CAPM
- Capital Market Line – risk return relationship for efficient portfolios.
- Security Market Line – Graphic representation of CAPM and market price of risk in capital markets.
- Risk Return Relationship
- Risk Free Rate
- Risk Premium on market portfolios
- Beta – Measure the risk of an individual asset value to market portfolio. Assets- (a) Defensive Assets (b) Aggressive Assets
After the brief review of the above assumptions, the requirements for CAPM can be summarized as follows.
Risk is measured by variance of expected returns. There are two components of Risk – systematic (non-diversifiable) and unsystematic (diversifiable). For diversifiable risk, the investor makes a proper diversification to reduce the risk and for the non-diversifiable portion, he/she uses the relevant Beta measure to adjust to his requirement or preferences. According to this approach, the cost of equity is reflected by the following equation
kj = Rf + Bj(km – Rf)
Where:
kj = expected or required rate of return on security j
Rf = risk-free rate of return
Bj = Beta coefficient of security j
km= return on market portfolio
Under CAPM, the equilibrium situation arises when all frictions, like taxes, divisibility transaction costs and different risk-free borrowing and lending rates are assumed away. Equilibrium will be brought about by changes in prices due to changes in demand and supply.
