What Investment Bankers Should Know about the Capital Asset Pricing Model - dummies

What Investment Bankers Should Know about the Capital Asset Pricing Model

By Matt Krantz, Robert R. Johnson

The CAPM is a financial model that is helpful to investment bankers. It was developed in 1964 by Nobel Prize winner and Stanford finance professor William Sharpe. It transformed the way that financial professionals think about risk and return.

Sharpe built on earlier work by Nobel laureate Harry Markowitz who first advanced the notion that the risk of an asset should be measured not in isolation, but with respect to that asset being added to a portfolio or collection of assets.

In other words, an asset may look very risky if just examined by itself, but the real measure of risk should be how it adds to or reduces the risk of an already existing portfolio — because most people hold a portfolio of assets and not simply a single asset.

Beta is the measure of risk

The intuition behind the CAPM is that you measure an asset’s risk relative to the average risk of the market. For simplicity’s sake, most analysts define the market as the most widely followed market indices.

The measure of risk for the CAPM is called beta (β). An asset’s beta is calculated by determining, on average, if an asset is more or less volatile than the market as a whole.

By definition, the market has a beta equal to 1.0. If an asset is less volatile than the market, it will have a beta lower than 1.0. If an asset is more volatile than the market, it will have a beta greater than 1.0.

The good news is that you don’t need to compute betas. Many financial websites compute betas for you, and you can simply look them up. For instance, Yahoo! Finance, Thomson Reuters, and MSN Money report betas for securities.

Betas are estimates calculated over different time periods and in relation to different indices, so you’ll find that the betas reported by different providers will vary. You’ll also find that the beta for a particular security will vary over time.

Here is a listing of betas for several Dow Jones Industrial Average components as of July 16, 2013. You’ll see that according to the beta measure, Alcoa is much more risky — when added to a portfolio — than the market, while Johnson & Johnson is much less risky than the market. American Express, on the other hand, has a risk nearly identical to the market.

Stock Beta
Alcoa 1.94
American Express 0.99
General Electric 1.32
IBM 0.73
Johnson & Johnson 0.40

Source: Yahoo! Finance

How to apply the CAPM

All you need to know to estimate the required rate of return on equity (re) according to the CAPM are the following three inputs:

  • Risk-free rate of return: This is generally the current yield on 90-day Treasury bills issued by the U.S. government, but some analysts use a longer-term (10-year or 30-year U.S. government bond rate). You can look up this rate on any number of financial websites including Yahoo! Finance and Bloomberg. On July 16, 2013, the return on 90-day Treasury bills was 0.03 percent — a historically low yield!

  • Market risk premium: The market risk premium is simply defined as the expected return on stocks minus the return on U.S. Treasury bills. It is, in effect, the premium an investor earns for investing in the market versus simply investing in Treasury bills. This is where the art of investment banking comes in.

    There is no one source to look up what the market risk premium is, so the analyst must estimate it. One method is to look at history and see what it has averaged over a long period of time. The market risk premium from 1926 through 2011 is 8.15 percent — computed as the difference between the return on large stocks (11.77 percent) and the return on Treasury bills (3.62 percent).

  • Beta: You can look up a stock’s beta on a number of financial websites.

The first two inputs — the risk-free rate of return and the market risk premium — are the same for all stocks. So, according to the CAPM, the only variable that changes when you examine different stocks is beta.

The formula for computing the required rate of return on equity according to the CAPM is:

re = rf + β × (Market Risk Premium)

where rf is the risk-free rate and β is, well, beta.

To compute the required rate of return on General Electric equity, you simply plug the values into the equation:

re = 0.03 + (1.32 × 8.15) = 10.79%

So, the appropriate required return on equity capital for General Electric stock, according to the CAPM, is 10.79 percent.

The same calculation for IBM results in a much lower required rate of return on equity capital of 5.98 percent. Because IBM is considered much less risky than General Electric, investors will require a lower expected rate of return to invest in it.

Postscript on CAPM

One of the great debates in academic financial circles involves how well CAPM work. More data-based studies have been done critiquing the CAPM than on virtually any other topic in finance over the past half-century. At best, the evidence on the veracity of CAPM is mixed. Suffice it to say that the relationship between risk and return isn’t as simple or as reliable as the CAPM hypothesizes.

The evidence is not consistent with a simple straight-line (or linear) relationship between risk (beta) and return over either long-term or short-term time periods. In fact, over some time periods, lower-beta stocks have outperformed higher-beta stocks — and, stocks in general have underperformed government bonds.

One of the key insights to the CAPM is that the only risk that investors are compensated for — and the only risk that they should be concerned with — is the systematic risk of the firm relative to the broad market. All other risks can be diversified away by holding a well-diversified portfolio of many securities.