Capital Asset Pricing Model
Investors which have been around for a while will already
know about the various methods, measurements and models to analyse stocks and
shares of companies. However, if you’re just a starter or perhaps you would
just like to know more about investing, then Capital Asset Pricing Model is an
important one to learn about.
Capital Asset Pricing Model or CAPM (pronounced Cap-em) of
the more well-known and influential models in the practical world of finance, which
was first expounded by Nobel prize-winner William Sharpe and other
theoreticians. The CAPM, in a nutshell, says that returns the higher the risk,
the higher the return.
As argument goes, it is logical to be fully diversified
hence investors creating large portfolios (you can read about portfolio theory
in one of my previous blogs) and by doing this, investors are eliminating unsystematic
risk, which is risk that can be diversified away. So once the unsystematic risk
in eliminated, it leaves investors to concentrate on systematic risk-risk which
cannot be diversified away. According to Arnold 2010, CAPM as measured by beta,
is the only factor affecting the level of return required on a share for a
completely diversified investor.
ra = rrf + Ba (rm-rrf)
Where:
rrf = the rate of return for a risk-free
security
rm = the broad market's expected rate of
return
Beta
In relation to CAPM, beta is the only relevant measure of a
stocks risk. It measures the covariance between returns of a particular share with
the returns on the market as a whole. Beta is found by statistical analysis of individual, daily share price
returns, in comparison with the market's daily returns over precisely the same
period.
The security market line shows the relationship between
beta and the expected rate of return E(Ri).
·
E(Rm) represents the expected market return
·
Rf represents the risk free rate
A beta of 1 indicates that the security's price will move
with the market. A beta of less than 1 means that the security will be less
volatile than the market. A beta of greater than 1 indicates that the
security's price will be more volatile than the market. For example, if a
stock's beta is 1.3, it's theoretically 30% more volatile than the market.
Investors can use CAPM to decide what price to pay for
stocks and shares, so if company A is riskier than company B, then investors
should be compensated for taking on the higher risk by lowering the prices. Compensation
in CAPM is given in two ways– time value of money and risk. The time value of
money is represented by the risk-free (rf) rate in the formula and compensates
the investors for placing money in any investment over a period of time. The
other half of the formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk. This is
calculated by taking a risk measure (beta) that compares the returns of the
asset to the market over a period of time and to the market premium (Rm-rf).
CAPM is
important because it is most often used to determine what the fair price of an investment should be. When you calculate the risky asset's rate of return using CAPM, that rate can then be
used to discount the investment's future cash flows to their present value and thus arrive at the investment's fair value.
However,
criticism of CAPM came in the 80’s and 90’s where researchers discovered that
actually there was no relationship at all or that beta had barely an influence
on the return shares produced, and said that there were other factors which
determine the return on shares. The impact of this revelation caused some
people to say beta was dead, but on the contrary others were saying it is alive
and well. In reality, CAPM is still going strong and reaching new heights of
popularity, particularly with students like myself who study this as part of
their university course.
No comments:
Post a Comment