2.5 Capital Asset Pricing Model (CAPM)

One of valuation's great difficulties is relating returns and risk. Although we might be able to anticipate expected returns, the likelihood of their occurring (risk) is often hard to quantify.

The Capital Asset Pricing Model is one of the best known (and controversial) methods for quantifying risk. The model’s message is amazingly simple: An investment’s risk premium varies in direct proportion to the investment’s volatility compared to the rest of a competitive, efficient market.

At first you may find the way that CAPM relates risk and return to be inpenetrable. But just like a jet plane breaking the sound barrier (see above) remember the CAPM model’s function is simplicity. For many, CAPM peels away layers of complexity that obscure an understanding of risk and return.

Of course, as with any economic model, the elegance of the theory comes at a cost. CAPM depends on simplifying assumptions that may often seem at odds with reality. We will consider those assumptions at the end of this section and draw some common-sense conclusions about how much faith we should place in our model.

2.5.1 - CAPM basics

A widely-used valuation model, known as the Capital Asset Pricing Model, seeks to value financial assets by linking an asset's return and its risk. Armed with two inputs -- the market's overall expected return and an asset's risk compared to the overall market -- the CAPM predicts the asset's expected return and thus a discount rate to determine price! (More 2.5.1>>)

2.5.2 - Theoretical basis of CAPM

Valuation of assets, like any art, has its techniques. And the techniques all have hidden secrets, sometimes skeletons in the closet. The CAPM is a case in point. To appreciate the CAPM's pitfalls, it is important to know how the model is derived. In particular, CAPM assumes that investors desire more return/less risk, that an "optimal" portfolio is one with the best return/risk mix, that it is possible to remix an "optimal" portfolio with risk-free assets, and that this produces a "capital market line." (More 2.5.2>>)

2.5.3 - Critique of CAPM

• Critical assumptions of CAPM
• Empirical tests of CAPM
• Readings on CAPM

CAPM is not without controversy. It rests on some critical (and questionable) assumptions. And empirical tests do not confirm it entirely. A It nonetheless has had signficant staying power and there is a wide body of literature that slices and dices it. (More 2.5.3>>)

A fighter jet breaking the sound barrier.