Capital asset pricing model

The capital asset pricing model (CAPM) estimates the return investors should require from a security given its exposure to market risk. It combines a risk-free return with a premium derived from the expected market return and the security’s beta.

When to use it

• To estimate the required return or discount rate for a security, such as a company’s shares.
• To examine the trade-off between systematic risk and expected return.
• To estimate a cost of equity for valuation and capital-investment analysis.

Origins

CAPM was developed independently during the 1960s by William F. Sharpe, John Lintner and Jan Mossin, with related earlier work by Jack Treynor. Sharpe’s route began in 1960 when he approached Harry Markowitz for a doctoral topic and extended Modern portfolio theory (Finance); thumbnail basis: modern-portfolio-theory-figure-01.jpg. from portfolio selection to equilibrium asset prices. His nineteen sixty-four article “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk” became the best-known formulation. In 1990 Sharpe shared the Nobel Memorial Prize in Economic Sciences with Markowitz and Merton Miller for pioneering contributions to financial economics.

What it is

CAPM separates return into compensation for time and compensation for systematic risk. The risk-free rate, R_f, represents the return available without taking market risk, often approximated using a government-security yield with a maturity and currency appropriate to the cash flows. The market risk premium, R_m − R_f, is the additional return expected from the market portfolio.

Beta, β_a, measures how sensitively an asset’s returns move with the market. The market beta is 1.0. A diversified large-company share may have a beta near 1.0; a technology stock whose returns amplify market movements may exceed 1.0; a defensive utility may have a beta below 1.0. Beta describes market-related risk, not every source of uncertainty in the company.

Sharpe’s relationship is:

r_a = r_f + β_a (r_m − r_f)

where R_a is the asset’s required return, R_f the risk-free rate, β_a the asset beta and R_m the expected market return. In words, required return equals the risk-free rate plus beta multiplied by the market’s excess return.

Suppose the risk-free rate is 3.0 per cent, the stock beta is 2.0 and the expected market return is 6.0 per cent. CAPM gives 3 per cent + 2.0 × (6 per cent − 3 per cent) = 9.0 per cent. For securities assessed in the same market and period, the risk-free rate and market premium are common inputs; beta drives the difference in required return.