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CAPM’s Contribution to the Stock Market

The Capital Asset Pricing Model (CAPM) is a mathematical, analytical formula to help investors make the wisest decisions on the stock market. Before purchasing a common stock, an investor may use the CAPM (a mathematical formula) to estimate its expected returns. The Model may be used for all kinds of assets.

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In brief, the CAPM helps to explain “the relationship between the risk of a particular asset or stock, its market price, and the expected return to the investor (“Capital Asset Pricing Model or CAPM,” 2007). By using CAPM as a tool to project expected returns from stocks, investors automatically affect the demand and prices of stocks sold on the market. The CAPM starts out with the assumption that there are two kinds of risks that must be assessed before an investment decision is made. Systematic risk includes risks facing the market as a whole and that cannot be dampened through portfolio diversification. Examples of systematic risks include rates of interest and economic slumps (McClure, 2008).

While systematic risks must affect all stocks at the same time, unsystematic risks or specific risks are risks that are “specific to individual stocks and can be diversified away as the investor increases the number of stocks in his or her portfolio (McClure). ” Of course, good investors are well-versed in investment theories such as the modern portfolio theory, which clearly states that diversification cannot resolve the issue of systematic risks, although specific risks may be easily handled by diversifying an investment portfolio.

CAPM was developed as a way to address the issues raised by the modern portfolio theory. This Model is a tool to measure systematic risks as well (McClure). The Risk Glossary explains the importance of estimating systematic risk before the formula for measuring such risk is described: According to CAPM, the marketplace compensates investors for taking systematic risk but not for taking specific risk. This is because specific risk can be diversified away. When an nvestor holds the market portfolio, each individual asset in that portfolio entails specific risk, but through diversification, the investor’s net exposure is just the systematic risk of the market portfolio. Systematic risk can be measured using beta. According to CAPM, the expected return of a stock equals the risk-free rate plus the portfolio’s beta multiplied by the expected excess return of the market portfolio. Specifically, let and be random variables for the simple returns of the stock and the market over some specified period.

Let be the known risk-free rate, also expressed as a simple return, and let be the stock’s beta. Then where E denotes an expectation (“Capital Asset Pricing Model,” 1996). The formula of CAPM is considered its conclusion (“Capital Asset Pricing Model”). To put it simply, the formula states that “excess expected return” of a stock is dependent on the beta of the stock rather than the stock’s volatility (“Capital Asset Pricing Model”). The same can be stated for an investment portfolio.

Another way to explain the formula is that “the stock’s excess expected return over the risk-free rate equals its beta times the market’s expected excess return over the risk free rate (“Capital Asset Pricing Model”). ” Or, excess expected return from a stock is dependent on systematic risk rather than the total of risks (“Capital Asset Pricing Model”). As suggested previously, by knowing the beta and expected returns for a certain stock or asset, investors are able to bid up or down its price. Expected returns are adjusted so long as the formula has not been satisfied.

Thus, the Capital Asset Pricing Model ends up predicting the equilibrium price of a stock or asset. One of the assumptions of the model is that all investors agree on the expected return of certain stock or asset as well as the beta. Although this assumption is unrealistic, the CAPM is believed to affect the stock market by urging investors to raise the demand for particular assets or stocks as compared to others, based on the information they obtain through the use of the Model (“Capital Asset Pricing Model”).

Apart from the unrealistic assumption of CAPM mentioned above, there are other problems with the Model that experts have identified by way of research. As an example, Eugene Fama and Kenneth French, upon considering expected returns on the American Stock Exchange, Nasdaq and the New York Stock Exchange for a period of 27 years, found that the differences of beta do not consistently describe the performance of stocks (McClure).

McClure reports that the study conducted by Fama and French is not the only one that raised doubts about the validity of the Capital Asset Pricing Model. A major problem with the Model is the fact that beta cannot be used as a sure predictor of the reaction of stocks to various changes. All the same, the CAPM continues to be used by countless investors around the globe (McClure). In other words, beta continues to affect investment decisions that run the stock market day after day.

References

Capital Asset Pricing Model. (1996). Risk Glossary. Retrieved Nov 4, 2008, from

http://www.riskglossary.com/link/capital_asset_pricing_model.htm.

Capital Asset Pricing Model or CAPM. (2007). Money Zine. Retrieved Nov 4, 2008, from

http://www.money-zine.com/Investing/Stocks/Capital-Asset-Pricing-Model-or-CAPM/.

McClure, B. (2008). The Capital Asset Pricing Model: An Overview. Investopedia. Retrieved

Nov 4, 2008, from http://www.investopedia.com/articles/06/CAPM.asp.