CAPITAL ASSET PRICING MODEL (CAPM)
It was developed by William Sharpe (1964), John Lintner (1965) and Jan Mossin.
CAPM is an extension of Harry Markowitz’s modern portfolio theory (MPT) in 1959.
It explains the relationship between expected return and risk of an asset.
Markowitz showed that investors can build efficient portfolios that maximize return for a given level of
risk through diversification.
However MPT did not specify how assets should be priced individually. CAPM solved this gap.
Investors need compensation for time value of money (risk free rate) and for taking on risks (market risk
premium)
It states that the expected return on a security= risk free rate + beta*market risk premium. ie
ERi= Rf + Bi(ERm- Rf)
Where; ERi is Expected return of an asset
Rf is Risk free rate
ERm is Expected return of the market
Bi is Measure of the asset’s sensitivity to market risk.
ELEMENTS OF CAPM
Risk free rate (Rf), minimum return an investor expects in any investment assuming zero loss.
Market return (Rm), Average return of the market portfolio
Market risk premium( Rm- Rf), Extra return investors demand for investing in risk assets.
Beta, sensitivity of asset returns to market returns
Expected return(ERi), The return predicted by CAPM
Systematic risk and unsystematic risk are other elements of CAPM
Systematic risks are risks that affect the entire market and it’s beyond the companies control for
example inflation, exchange rate, taxation, interest rates. These risks can’t be eliminated by
diversification. They apply across the market. These risks are the minimum level of risks an investor or a
company bears in any given investment.
Unsystematic risks; these are risks that are unique to the company, industry, or asset. They can be
eliminated by diversification for example strikes, law suits, loss of a key account.
Sources/ Causes of unsystematic risks
Business risks; Poor management decisions, operational inefficiencies
Financial risks; High debt levels, inability to meet obligations
Industry specific risk; Changes in industry regulations, new competitors, technological changes that
disrupt a specific sector.
Management risk; Leadership failures, fraud or poor corporate governance
Types of unsystematic risks
Event risk; Natural disasters, accidents affecting firms like fire
Competitive risk; Losing market share to rivals
Financial risk; Management of capital or liquidity problems
A graph showing relationship of risk against number of securities
Systematic risks affect all securities and cannot be eliminated by diversification
The systematic risk is the minimum risk that remains no matter how many securities you add.
On the graph, it appears as a constant horizontal line show casing the minimum level of risks every
investor must bear.
The unsystematic risk affects a specific company or firm.
As more securities are added to the portfolio, the risk reduces.
Eventually with sufficient diversification, the risk approaches zero.
Main assumptions of the Capital Asset Pricing Model (CAPM):
1.Investors are rational and risk-averse
They seek to maximize returns for a given level of risk.
They prefer higher returns and lower risk.
2. Single-period investment horizon
All investors make decisions based on the same single holding period (e.g., one year).
3. Perfect capital markets
No taxes, no transaction costs, no restrictions on short selling.
All assets are infinitely divisible (can be bought in fractions).
Information is freely available and simultaneously accessible to all investors.
4. Existence of a risk-free rate (Rf)
Investors can borrow or lend unlimited amounts at the same risk-free interest rate.
5. Homogeneous expectations
All investors have the same expectations about returns, variances, and covariances of securities.
6. Market efficiency
Security prices fully reflect all available information.
No investor can consistently achieve abnormal returns.
7. Investors focus only on mean and variance (Mean-Variance Optimization)
Investment decisions are based solely on expected returns (mean) and risk (variance/standard
deviation).
8. Systematic risk is the only relevant risk
Unsystematic (firm-specific) risk is irrelevant since it can be eliminated through diversification.
Strengths of CAPM
✅ Provides a simple and clear way to estimate expected returns.
✅ Considers systematic risk (beta), which is relevant in diversified portfolios.
✅ Widely used in corporate finance, portfolio management, and valuation.
✅ Helps in capital budgeting decisions by providing a discount rate for NPV analysis.
✅ Empirically shows that higher risk (beta) → higher expected return.
Weaknesses of CAPM
❌ Assumptions are unrealistic (no taxes, no transaction costs, perfect markets).
❌ Estimating beta and market return can be difficult and unstable over time.
❌ Ignores unsystematic risks (company-specific risks).
❌ Investors do not always behave rationally (behavioral finance critique).
❌ In real markets, borrowing and lending at a risk-free rate is impossible.
❌ Empirical evidence shows CAPM does not always hold – sometimes low-beta stocks outperform.
Example
Suppose the risk-free rate is 4%, the expected market return is 10%, and a stock has a beta of 0.8. Using
CAPM, the expected return is:
E(Ri) = 4% + 0.8(10% - 4%) = 8.8%
This means that investors would require an 8.8% return to justify investing in this stock. If the stock is
expected to return more than 8.8%, it is undervalued, but if it is expected to return less, it is overvalued.
The CAPM equation is therefore a practical tool for evaluating investment opportunities and calculating
the cost of equity for firms.
