Generally, it is said that the more risk you take higher will be the return and vice versa. But at the same time, there is no guarantee that one will actually get high returns for a higher risk. But one will get high returns only when s/he is willing to accept the possibility of losses, as the amount of losses in taking high risks are also high. It’s important that one balances between the risk and return of his/her portfolio.
Diversification enables you to reduce the risk of your portfolio without sacrificing potential returns. But no matter how much you diversify your investments, it’s impossible to get rid of all the risk. As investors, all of us want that we get a rate of return that compensates for the risk taken. With the help of the Capital Asset Pricing Model (CAPM) we can calculate the investment risk and the return on investment we should expect depending on the risk taken.
The following table provides some examples of common types of investments classified according to their potential return and investment risk.
|Potential Return||Investment Risk (Volatility)||Examples of Common Investments|
· Variable annuities invested in high-quality bond sub-accounts
|Very Low||Very Low||
CAPITAL ASSET PRICING MODEL (CAPM)
What is CAPM?
The capital asset pricing model was the work of financial economist (and later, Nobel laureate in economics) William Sharpe, set out in his 1970 book “Portfolio Theory and Capital Markets.” Capital Asset Pricing Model (CAPM) is a model that describes the relationship between systematic risk and expected return on assets. CAPM is widely used throughout finance for the pricing of risky securities, generating expected returns for assets given the risk of those assets and calculating costs of capital.
There are some assumptions of the CAPM Model which are:
- Investors are wealth maximizers who select investments based on expected return and standard deviation.
- Investors can borrow or lend freely at a risk-free (or zero risk) rate.
- There are no restrictions on short sales (selling securities that you don’t yet own) of any financial asset.
- All investors have the same expectations related to the market.
- All financial assets are fully divisible (you can buy and sell as much or as little as you like) and can be sold at any time at the market price.
- There are no transaction costs.
- There are no taxes.
- No investor’s activities can influence market prices.
- The quantities of risky securities in the markets are given and fixed.
Expected Return(ER) = Risk free rate of return (Rf)+Market risk premium(Rm-Rf) x beta of security(β)
ER = Rf + βx(Rm-Rf)
Rm = Expected return on market
The general idea behind CAPM is that investors need to be compensated in two ways:
- Time value of money
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 CAPM 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): the return of the market in excess of the risk-free rate. Beta reflects how risky an asset is compared to overall market risk and is a function of the volatility of the asset and the market as well as the correlation between the two.
If this expected return does not meet or beat the required return, then the investment should not be undertaken. And if it exceeds the required return then it would be favorable to take the asset.
Example: the risk-free rate of return is 8% and the expected return on the market portfolio is 14%. The beta of the stock is 1.25. What will be the expected return of the security?
Rf = 8%
Rm = 14%
Β = 1.25
ER = Rf + β(Rm-Rf)
ER = 8 + 1.25x(14-8)
ER = 15.5%
Why CAPM is important?
The CAPM formula is widely used in the finance industry by various professions such as investment bankers, financial analysts, and accountants. It is an integral part of the Weight Average Cost of Capital (WACC) as CAPM calculates the cost of equity.
WACC is used extensively in financial modeling. It can be used to find the net present value (NPV) of the future cash flows of an investment and to further calculate its enterprise value and finally its equity value.
Advantages of CAPM
The CAPM has several advantages over other methods of calculating required return, which is as follows:
- CAPM considers systematic risk, which is usually left out in other return models. Systematic risk is an important variable that needs to be considered as this is a risk which cannot be eliminated.
- CAPM model is based on the assumption that the investors hold diversified portfolios, which eliminates the unsystematic risk.
- This model is very simple to use.
- It is superior to the Weight Average Cost of Capital (WACC) in providing discount rates for use in investment appraisal.
Disadvantages of CAPM
CAPM model also has a few drawbacks which are:
- The risk-free rate of return (Rf): The yield on short-term Government debt, which is used as a substitute for the risk-free rate of return, is not fixed but changes on a daily basis according to economic circumstances. In other words, Rf is a volatile rate of return.
- Return to the market (Rm): return on the market is the sum of capital gains and the dividends for the market. And in the short run, the market may give negative returns instead of positive returns also. As a result, a long-term market return is utilized to smooth the return.
- Beta (β): Beta values are now calculated and published regularly for all stock exchange-listed companies, earlier which was not possible. The problem here is that uncertainty arises in the value of the expected return because the value of beta is not constant, but changes over time.
- CAPM is based on various assumptions out of which one of them is that the investors can borrow and lend at a risk-free rate. This is unattainable in reality.