Capital Asset Pricing Model (CAPM): Definition, Formula, Advantages & Example

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  • 0:05 The Capital Asset…
  • 1:59 The Beta Coefficient
  • 2:56 Formula & Examples
  • 5:35 Uses of the CAPM
  • 6:51 Advantages of the CAPM
  • 7:29 Lesson Summary
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Lesson Transcript
Instructor: Jay Wagner
Learn about the Capital Asset Pricing Model (CAPM), one of the foundational models in finance. We'll look at the underlying assumptions, how the model is calculated, and what it can do for you.

The Capital Asset Pricing Model

In finance, one of the most important things to remember is that return is a function of risk. This means that the more risk you take, the higher your potential return should be to offset your increased chance for loss.

One tool that finance professionals use to calculate the return that an investment should bring is the Capital Asset Pricing Model which we will refer to as CAPM for this lesson. CAPM calculates a required return based on a risk measurement. To do this, the model relies on a risk multiplier called the beta coefficient, which we will discuss later in this lesson.

Like all financial models, the CAPM depends on certain assumptions. Originally there were nine assumptions, although more recent work in financial theory has relaxed these rules somewhat. The original assumptions were:

  1. Investors are wealth maximizers who select investments based on expected return and standard deviation.
  2. Investors can borrow or lend unlimited amounts at a risk-free (or zero risk) rate.
  3. There are no restrictions on short sales (selling securities that you don't yet own) of any financial asset.
  4. All investors have the same expectations related to the market.
  5. 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.
  6. There are no transaction costs.
  7. There are no taxes.
  8. No investor's activities can influence market prices.
  9. The quantities of all financial assets are given and fixed.

Obviously, some of these assumptions are not valid in the real world (most notably no transaction costs or taxes), but CAPM still works well, and results can be adjusted to overcome some of these assumptions.

The Beta Coefficient

Before we can use the CAPM formula, we need to understand its risk measurement factor known as the beta coefficient. By definition, the securities market as a whole has a beta coefficient of 1.0. The beta coefficients of individual companies are calculated relative to the market's beta. A beta above 1.0 implies a higher risk than the market average, and a beta below 1.0 implies less risk than the market average. Most companies' betas fall between 0.75 and 1.50, but any number is possible, including negative numbers; a negative beta would be highly unlikely, however, since it would imply less risk than a 'risk free' investment.

For actual use, the beta coefficients of most companies can be found on financial websites as well as in electronic publications. You can do a quick search to find companies' beta coefficients.

Formula and Examples

The CAPM formula is sometimes called the Security Market Line formula and consists of the following equation:

r* = kRF + b(kM - kRF)

It is basically the equation of a line, where:

r* = required return

kRF = the risk-free rate

kM = the average market return

b = the beta coefficient of the security

You will sometimes see the kM - kRF term replaced by kMRP. kMRP (the market risk premium) = kM - kRF, so this is just a shortcut when the market risk premium has already been calculated. Remember again that the beta of the market is 1.0, so kMRP is just the additional return required from the market as a whole.

We should also take a moment to talk about the risk-free rate, kRF. Investments are subject to many risks that may come from the economy, the nature of the market, the industry in which a company operates, or the company itself. Of these risk factors, the only one that is universal is the risk that inflation will decrease an investor's purchasing power. In theory, the risk-free rate is the return that an investment with no risks should earn, but in practice it includes the ever-present risk of inflation.

Let's calculate a couple of required returns using fictional companies X and Z to see how this works. For our calculations, we will use the return on Company X as the risk-free rate and the 1-year return on Company Z as the market return. Let's hypothetically use beta coefficients for Company X and Company Z as 0.10% and 20.63%, respectively. Hypothetically, let's also provide Company R, S, and T with these current beta coefficients:

Company R = 0.25

Company S = 1.82

Company T = 0.68

Based on these figures, Company R, with a beta of 0.25, should have a required return of 5.2325 or 5.23%.

Company S, on the other hand, would have a required return of 37.4646 or about 37.46%.

That's quite a gap, but it reflects the additional risk an investor accepts when investing in Company S rather than Company R.

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