CAPM Concept, Assumptions, Formula, Advantages, Limitations

What is CAPM Full form?

CAPM stands for Capital Asset Pricing Model. CAPM provides an estimation of expected rate of return with respect to risks associated with the said investment. The model analyzes the total risk factor which is a combination of both systematic risks and unsystematic risks. It provides a framework to the investors where they can assess whether the risk premium is proportional to the the systematic risk(beta co-efficient).

CAPM Features

1. It is based on a notion that the diversifiable risk of a security is diluted when more securities are added to the portfolio.
2. It considers the Systematic Risk contribution to the total risk when analyzing the required rate of return.
3. It provides relation between expected return and systematic return.

CAPM Formula

The formula for expected rate of return is given by –

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CAPM Assumptions

1. Investors are efficient and risk averse.
2. Investors choose portfolio on the basis of expected return and risks involved.
3. Investors have same time and resources to assess investments’ information.
4. Investors are rational and their aim is to maximize returns.
5. Investors have no restrictions on borrowing and lending of the asset at risk free rates.
6. Investors have same expectations of risk and return over identical time horizon.
7. No investor can single-handedly influence the market.
8. All assets are marketable and divisible.
9. There is no transaction cost, tax or any other market imperfections.
10. No restrictions on the amount of shares that can be short by investors.

CAPM Advantages

1. It suggests diversification for risk minimization.
2. It provides estimated required rate of return in a security.
3. It takes into account systematic risk which is an important aspect of any investment.
4. It is more insightful then WACC especially in providing discount rates.

CAPM Limitations

1. The assumptions of CAPM would not hold good in real world scenario.
2. It is difficult to calculate risk free rate as it keeps changing daily.

CAPM Examples

To get a clarity on CAPM let us see a simple example. 1. For a security “P” following is the data –

Risk Free Return (R_f) – 6%

Beta of the security (β) – 1.1

Return on Market Portfolio (R_m) – 19%

Calculate expected rate of return using Capital Asset Pricing Model

Solution –

R_e = R_f + { β_p x ( R_m – R_f ) }

R_e = (6%) + [(1.1){(19%)-(6%)}]

R_e = (6%) + {(1.1)(13%)}

R_e = 6% + 14.3%

R_e = 20.3%

The expected return for security “P” would be 20.3 %

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