This can be important for factor-based strategies which often target market abnormalities and mispricing in order to improve returns. Factor-driven strategies include smart beta and risk premia (which can amplify returns by using leverage, derivatives and short positions).
The CAPM model offers a theoretical look into how financial markets price stocks, which allows investors to gauge expected returns. Stock returns are a function of dividends plus capital gains, divided by the price at which the asset was bought.
CAPM, as one of the central focus areas of modern portfolio theory, has a number of applications in the investment universe including estimating the cost of equity capital.
The standard CAPM equation is:
Expected return = RF + β(RM – RF)
RF = the risk-free rate of return (usually represented by treasury bills)
β = the investment’s beta value (which measures its sensitivity to market movements)
RM = Expected return from the market
The risk-free rate of return is often represented by ‘safe’ government bonds since these have little risk of default and interest payments are regular and easily predicted.
The second part of the equation [β(RM – RF)] quantifies an investment’s risk premium and determines how much compensation investors demand for buying into the asset’s inherent risk. The fund’s sensitivity to market movements is multiplied by the excess return expected from the market (or the portion of return over and above a risk-free alternative).
When markets become highly volatile, a stock with a beta of more than 1 will experience even greater volatility than the market, which could bring about high returns during upside volatility or heavy losses during downside volatility.
One limitation of the CAPM model is that it applies systematic risk (or market risk), rather than idiosyncratic risk. This is because of the assumptions of diversification and efficient markets.
Traditional size-based indices, like the S&P 500 Index of large US stocks, are a proxy for market risk exposure and allow investors to capture the market risk premium. Alternative indices can target idiosyncratic risk premiums in order to deliver better returns or control risk.
Another limitation of CAPM is the ability to accurately gauge expected market returns. Market returns are often predicted by assuming the market’s risk premium will remain in line with long term averages. Based on that assumption, the expected return from the market, or from a market portfolio, can be calculated by adding the market risk premium to the risk-free rate.
The basic CAPM model can also be expanded to take other factors into account and provide a more complex forecast of expected returns. A number of CAPM variations have been produced in recent years.
In addition, several other financial models use CAPM to calculate risk-return ratios. Jensen’s measure, otherwise known as Jensen’s alpha.
Using CAPM to evaluate stocks
By looking at the expected return of an equity asset, investors can decide whether or not that asset is suitable for their required rate of return.
Consider an option to invest in the equity of an IT business. If US treasuries are yielding 1.5% (this is the risk-free rate), while the investment in focus has a beta value of 1.2 (it is more volatile or risky than the market) and the expected return from the market is 10%, then the security is expected to generate returns of 11.7%.
[Expected return = 1.5 + 1.2(10 – 1.5)]
In this example, the risk premium of the stock is 10.2%. If this meets or exceeds an investor’s required rate of return based on the asset’s risk, then the investment would be considered an attractive option. But many investors would consider an asset which offers the same expected return but with a lower beta (volatility risk) as more attractive.
The CAPM model, while widely adopted, is not often used on a standalone basis since it evaluates expected returns based on a simplified view of financial markets, ignoring their intricacies and abnormalities (including irrational market pricing by investors). Rather, this useful tool is best used in conjunction with other objective cost-of-capital models as well as subjective analysis.
The capital asset pricing model (CAPM) is a financial tool which helps investors to determine the price of an investment, based on its risk and expected return metrics.