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The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a number often referred to as beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.
The model was introduced by William Sharpe, Lintner and Mossin independently, though it is commonly attributed only to the first of them, who published it earliest (in 1964). Sharpe received the Nobel Prize in Economics (jointly with Harry Markowitz and Merton Miller) for his contribution to the field of financial economics.
According to the CAPM, the relation between a given asset i, and a proxy portfolio m (here, the market portfolio) is described as:
Where:
Once the expected return, , is calculated using CAPM, the future cash flows of the asset can be discounted to their present valueThe present value of a future transaction is the nominal amount of money to change hands, adjusted to account for the time value of money. A given amount of money is almost always more valuable sooner than later, so present values are generally smaller th using this rate to establish the correct price for the asset.
In theory, therefore, an asset is correctly priced when its observed price is the same as its value calculated using the CAPM derived discount rate. If the observed price is higher than the valuation, then the asset is overvalued (and undervalued for a too low price).
Alternatively, one can "solve for discount rate" for the observed price given a particular valuation model and compare that discount rate with the CAPM rate. If the discount rate in the model was lower than the CAPM rate then the asset is overvalued (and undervalued for a too high discount rate).
The CAPM returns the asset appropriate required return or discount rate - i.e. the rate at which future cash flows produced by the asset should be discounted given that asset's relative riskiness. Betas exceeding one signify more than average "riskiness"; betas below one indicate lower than average. Thus a more risky stock will have a higher beta and will be discounted at a higher rate; less sensitive stocks will have lower betas and be discounted at a lower rate. The CAPM is consistent with intuition - investors (should) require a higher return for holding a more risky asset.
Since beta reflects asset specific sensitivity to non-diversifiable, i.e. market, risk, the market as a whole, by definition, has a beta of one. Stock market indices are frequently used as local proxies for the market - and in that case (by definition) have a beta of one. An investor in a large, diversisifed portfolio (such as a mutual fund) therefore expects performance in line with the market.
The risk of a portfolioFinance In finance, a portfolio is a collection of investments held by an institution or a private individual. In building up an investment portfolio a financial institution will conduct its own investment analysis, whilst a private individual may make us is comprised of systematic risk and specific risk . Systematic risk refers to the risk common to all securities - i.e. marketThe capital market is the market for long-term loans and equity capital. Companies and the government can raise funds for long-term investments via the capital market. The capital market includes the stock market, the bond market, and the primary market. risk. Specific risk is the risk associated with individual assets. Specific risk can be diversifiedDiversification is a measure of the commonality of a population. Greater diversification denotes a wider variety of elements within that population. Diversification is of central importance in investments. Diversification reduces the risk of a portfolio. away (specific risks "average out"); systematic risk (within one market) cannot. Dependent on market, a portfolio of approximately 15 well selected shares (and more) would be sufficiently diversified to leave the portfolio exposed to systematic risk only.
An investor cannot expect to be rewarded for taking on diversifiable risk, (it is not rational to expose one's wealth to more risk than necessary). Therefore, the required returnIn finance, the return on investment ROI or just return is a calculation used to determine whether a proposed investment is wise, and how well it will repay the investor. It is calculated as the ratio of the amount gained (taken as positive), or lost (tak on an asset, that is, the return that compensates for risk taken, must be linked to its riskiness in a portfolio context - i.e. its contribution to overall portfolio riskiness - as opposed to its "stand alone riskiness." In the CAPM context, portfolio risk is represented by higher varianceThis article is about mathematics. Alternate meaning: variance (land use). In probability theory and statistics, the variance of a random variable is a measure of its statistical dispersion, indicating how far from the expected value its values typically i.e. less predictability.
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