Capital asset pricing model (CAPM)
The Capital Asset Pricing Model (CAPM) is a financial framework that describes the relationship between the risk of an investment and its expected return. Developed by economist William Forsythe Sharpe in the 1960s, CAPM provides a formula to calculate the expected return on an investment based on its systemic risk, often quantified by beta, and the risk-free rate of return. Investors use this model to assess whether the potential return of a risky investment compensates adequately for the risk involved, particularly when comparing it to safer investments like government bonds.
CAPM is relevant for various stakeholders, including accountants and financial analysts, as it aids in estimating the value of high-risk investments and informs investment decisions. The model acknowledges two types of risks: systemic risks, which impact the market as a whole, and unsystemic risks, specific to individual investments. While useful, CAPM's predictions are not infallible and can sometimes misjudge the actual risk associated with an investment. Overall, CAPM plays a crucial role in the financial decision-making process, helping investors navigate the complexities of risk and return in their investment choices.
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Capital asset pricing model (CAPM)
Capital asset pricing model, or CAPM, is a financial term used to explain the relationship between the risk and the expected return, or potential benefit, of a particular investment. A specific mathematical calculation is used to determine CAPM. The concept addresses the fact that those who invest in a less certain and riskier security expect to make a better-than-usual return. CAPM is important to those who need to know the potential future value of these investments for calculating the equity, or the difference between the value and the liability of an asset. Those who use CAPM include accountants, financial analysts, and investment bankers.
Background
Financial investing is the process of committing a sum of money to a certain project or enterprise with the intent of gaining a monetary profit. A person can invest directly in a business, in stocks or other shares of a company, in bonds or property, for instance. The intent is that the funds invested will be used in such a way that it will bring more money.
For instance, an investor who gives money to a business or company does so with the hope that the enterprise will become successful and grow, bringing in profit. The owners of the company use the money provided by the investor to buy and build what they need to make the company successful. For example, they may build a factory, hire workers, or buy the raw materials to make a product for sale. If they operate the business well, it should grow and make a profit. The investor then receives a share of that profit in exchange for having helped to fund the business.
Making a profit is rarely a guarantee, however, and investing nearly always involves some risk. Many things can go wrong, some of which can be controlled and some of which cannot. For example, a factory can burn down; the company owners could be inept at business and fail, or they could cheat the investor; the demand for the product they are making could decrease; factors such as weather could affect delivery or procurement of raw materials; or the economy could slow down to the point that consumers do not buy the company's product.
Risks are an inherent part of all investing, but some investments can be riskier than others. For instance, if someone invents a brand-new product and wants to begin manufacturing it, that person will often look for investors. In most cases, it will be riskier for the investors to put their money in the new product than to invest in a popular product with an established sales record. The new product might never sell well, or it might lose money before becoming popular, or it may initially sell well but stop selling after its novelty wears off. Those who invest in this unproven product will want a greater return on their investment because they are taking a bigger risk. However, this same uncertainty means that the investment could offer great potential for financial success, as many individuals who invested in early computers, cell phones, and video games discovered. CAPM helps to determine the value of these risky investments, measuring their potential value against the possible liability.
The capital asset pricing model originated as a theory put forth by American financial economist William Forsythe Sharpe in the 1960s. It was formerly outlined in Sharpe's 1970 book, Portfolio Theory and Capital Markets. Sharpe won the Nobel Prize in Economic Science in 1990 for his model.
Overview
Companies that want to raise money to support their businesses often sell stocks or shares in the company. Each stock entitles the investor to receive a certain percentage of the company's profits, paid as dividends at regular intervals. Investors can buy or sell these stocks in the stock market.
Investors involved in the stock market face two kinds of risk. Systemic risks in the investment market affect all investors and include recessions, depressions, interest rate changes, and wars. Unsystemic risks are specific to the particular investment or kind of investment made. The best way for an investor to avoid suffering great losses in stocks is to diversify, or to invest in many different kinds of companies. This minimizes the chance of losing a lot of money if something happens to cause the value of the stock from one company or industry to drop.
Sharpe's formula was based on the idea that the amount of any stock earned should be equal to the cost of capital, or the amount that a company needs to cover its costs before it begins to make a profit. It factored in the beta, or the measure of the stock's volatility. Volatility in stocks refers to how much the price fluctuates day to day, especially in comparison to the market as a whole. The beta determines how risky a stock is; the higher the beta number, the riskier the investment.
While risky investments can fail, leaving the investor with little or nothing to show for the investment, they also have the potential for large profits. Some investors are comfortable with taking such risks, while others are not. Those who are do so with the expectation that they could make a great deal of money. Sharpe's formula helps to determine what that payout might be.
The formula is Ra = Rrf + Ba (Rm – Rrf). In this formula, Ra is the expected return, or how much the investor expects to earn. Rrf is the risk-free rate, or the rate paid by a guaranteed investment such as a government bond. Ba is the calculated beta of the investment. Rm is the expected market return, another calculated value based on the overall market return for investments. The formula is sometimes written as ERi = Rf + i(ERm- Rf), with ERi as the expected return on investment, Rf as the risk-free rate, i as the beta of the investment, and (ERm- Rf) as the market risk premium.
The CAPM is important in several ways. Accountants and others who must calculate a person's value can use it to estimate the worth of a high-risk investment. Because the CAMP provides a measurable value for an investment's risk, investors can use it to determine if the payout for the investment is worth the risk and compare investments across the market; in other words, is the investor likely to make enough money to take a chance on the risky investment. It can also help a company's stockholders determine whether their investments are well-placed. However, like other models that attempt to predict risk, CAPM is not fool-proof and can under- or over-estimate an investment's risk. Using CAPM in combination with other financial analysis methods can provide a better, real-world view of an investment's potential risk and benefit.
Bibliography
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