An Overview of Capital Asset Pricing Model (CPAM)

        The capital asset pricing model, or CAPM, is a sort of financial model used in corporate finance to represent the association between the risk of a security (such as a stock) and the risk of the market as a whole. The capital asset pricing model (CAPM) is a financial model that assesses the expected rate of return on an asset or investment. It is used to evaluate the performance of equity share in the market. The Capital Asset Pricing Model (CAPM) transformed modern finance. The model, created in the early 1960s by William Sharpe, Jack Treynor, John Lintner, and Jan Mossin, established the first logical framework for relating the required return on an investment to the risk of that the investment. Sharpe, Markowitz, and Merton Miller shared the Nobel Memorial Prize in Economics in 1990 for their contributions to financial economics. Fischer Black (1972) created Black CAPM, often known as zero-beta CAPM, which does not assume the existence of a riskless asset. This variant was more resistant to empirical testing and experienced had an impact in the CAPM's widespread adoption. CAPM performs this by utilising the projected return on the market as well as a risk-free asset, as well as the asset's correlation or sensitivity to the market (beta). The CAPM has a few drawbacks, including as assuming unrealistic assumptions and relying on a linear interpretation of risk vs. return. Despite its drawbacks, the CAPM method is still commonly employed due to its simplicity and ease of comparison of investment choices. For instance, it is used in conjunction with modern portfolio theory (MPT) to understand portfolio risk and expected return.

Key Terms of CAPM

Expected Return: This is the expected gain or loss that an investor anticipates from keeping an asset over a specified time period. Typically, expected return is represented as a percentage.

Risk-Free Rate: The risk-free rate represents the theoretical return an investor would expect from a risk-free investment. It is sometimes approximated by the yield on government bonds, such as US Treasury bonds, under the premise that these are nearly risk-free.

Market Risk Premium: The additional return that investors seek for owning a hazardous asset versus a risk-free asset. It accounts for the additional risk of investing in the stock market as opposed to a risk-free asset.

Beta (β): Beta is a measure of how responsive a stock or portfolio is to general market changes. It measures the asset's volatility in comparison to the market. A beta of one indicates that the asset moves in parallel with the market, a beta less than one shows that the asset is less volatility than the market, and a beta greater than one indicates that the asset is more unpredictable.

Major Assumptions of CAPM

·       Assume that all information is available to all investors at the same time.

·       To maximise economic utility of assets.

·       The investors are rational, risk averse and they have homogeneous expectations.

·       Investors are well-diversified throughout a wide range of investments.

·       Investors can lend and borrow a limitless amount at the risk-free interest rate.

·       Investors are price takers, which means they have no impact on prices.

·       There are no transaction or taxation costs in trade.

Formula of CAPM

The CAPM formula is used to calculate the expected return of an asset:

Expected Return = Risk-Free Rate + (Beta × Market Risk Premium)

Mathematically, it can be represented as:

E(R) = Rf + β * (Rm - Rf)

(E(R) = Expected return on the asset

Rf = Risk-free rate

β = Beta of the asset

Rm = Expected market return)

As investment is a future-oriented activity, we cannot forecast the risk involved. The security market is highly sensitive and unpredictable, with considerable changes over time. The entire risk of a security is divided into two categories: unsystematic risk (the fraction unique to the company that can be diversified away) and systematic risk (the non-diversifiable factor that is linked to stock market movement therefore unavoidable). The standard CAPM measure of systematic risk is beta. It assesses a security's tendency to move in parallel with the overall performance of the stock market. The investors can exclude company-specific risk simply by properly diversifying portfolios, they aren't compensated for bearing unsystematic risk. And because well- diversified investors are exposed only to methodical risk, with CAPM the applicable threat in the fiscal request’s threat/ anticipated return tradeoff is methodical risk rather than total risk. therefore, an investor is awarded with advanced anticipated returns for bearing only request- related risk.

Security Market Line (SML)

The security market line (SML) is a line drawn on a chart that represents the capital asset pricing model (CAPM) graphically. The SML is able to analyse whether an investment asset expected return is favourable as compared to its level of risk.

The security market line is commonly used by portfolio managers and investors to evaluate the value of an investment product that they are considering in designing the portfolio. The SML is important in determining whether a security provides a favourable expected return in relation to its level of risk. When a security is plotted on the SML chart, it can be considered undervalued if it appears above the SML given its position on the map. It implies that the security generates a lower return instead of a major risk. Again, if the security plots below the SML, it is overpriced since the expected return is not worth the inherent risk. It is used to compare two investment options that provide the same return to determine which is a better investment opportunity in the current market.

Ashida. A. P, Assistant Professor of Commerce, Al Shifa College of Arts and Science, Keezhattur