What is the Capital Asset Pricing Model?

Risk

The Capital Asset Pricing Model or CAMP can be defined as a financial model that can be used in order to determine the theoretically relevant required rate of return from an asset so that decisions can be made regarding the addition of assets to a well-diversified portfolio. Thus, the main aim of CAPM is to calculate the required return depending upon the risk management. This model uses a risk multiplier, known as beta coefficient to calculate the required return.

Founders of this model:

This theory of Capital Asset Pricing Model was first introduced by Jack Treynor, William F. Sharpe, John Lintner and Jan Mossin, based on the previous works of Harry Markowitz. In 1972, Fischer Black, an eminent economist invented a different version of this theory. It was called Black CAPM or zero-beta CAPM.

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CAPM formula:

The CAPM formula, also known as the Security Market Line Formula is –

r* = kRF + b(kM – kRF)

where,

r* = required return.

kRF = the risk-free rate.

kM = the average market return.

b = the beta coefficient of the security.

Assumptions used in this model:

Like other theories and models, the CAPM also works based on certain assumptions. The total number of assumptions behind this model is nine. They are:

  1. All the investors are risk-averse and sensible, which means they invest in less risky investments.
  2. All investors are equally informed about the conditions of the market. The market should be highly efficient and all the investors should have equal expectations from the market.
  3. The market should be ideal and perfect that is there should be no taxes, transaction charges, inflation, etc.
  4. All investors should be allowed to borrow or lend unlimited amounts under a zero risk rate.
  5. The investors are price takers; that is the investors should not be in a position to influence the prices in the market. The market should be in equilibrium.
  6. The quantities of the available assets should be fixed for a given time period.
  7. All the available financial assets are absolute liquid that is they can be sold at any time at the market price. The assets must be infinitely divided.
  8. The beta coefficient should be the only measure of risk.
  9. The required return should subject to normal distribution function.
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Limitations of this model:

  • According the theory, there should be no transaction fees on the markets but in reality there are transaction charges in the markets and it differs with different market participants.
  • The theory assumes that there are no taxes in the market but in real markets, various types of taxes are involved such as capital gains tax, income tax, etc.
  • The theory states that all the investors should have equal or homogenous expectations from the market, which is the market should be efficient. However, this is not the case in reality.
  • According to the CAPM, the beta coefficient is the only risk measurement involved but in reality, there are other risk measurements also such as liquidity risk, inflation risk, reinvestment risk, etc.

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