The Capital Asset Pricing Model (CAPM) serves several purposes in the field of finance, and it has been widely used for decades. For portfolio managers it offers a way to quantify the probable portfolio performance taking into account almost all aspects of investing. You can calculate the CAPM of your portfolio when rebalancing it or use it to compare two portfolios with different risk exposure.

The CAPM establishes a relationship between the expected return of an asset, the risk-free rate, the asset’s beta (a measure of its risk in relation to the overall market), and the expected market return. The formula for the CAPM is as follows:

Expected Return=Risk-Free Rate+β×(Market Return−Risk-Free Rate)

Here’s a breakdown of the components:

• Expected Return: The return an investor expects to receive from an investment.
• Risk-Free Rate: The theoretical return on an investment with no risk of financial loss (often represented by government bonds).
• Beta: A measure of an asset’s risk in relation to the overall market. A beta greater than 1 indicates higher risk, while a beta less than 1 suggests lower risk. If beta is zero, the portfolio is market neutral and is composed only of risk free assets. (The beta of our portfolio would be the weighted average of the stock betas in the portfolio.)
• Market Return: The expected return of the overall market. (Typically 8% for S&P500)

Example:

Let’s consider an example:

1. Risk-Free Rate: 2%
2. Beta: 1.2
3. Expected Market Return: 8%

Expected Return=2%+1.2×(8%−2%)

$\text{Expected Return}=2\%+1.2\times 6\%$

Expected Return=2%+7.2%=9.2%

In this example, according to the CAPM, the expected return for the asset would be 9.2%. This considers the risk-free rate, the asset’s beta, and the expected return of the overall market.

If your client is expecting returns in the excess of 9.2%, then you can reconsider for instance the stock picks and include more volatile stocks.

CAPM is useful also outside of portfolio management. Here are some of the key applications and benefits of CAPM:

1. Expected Return Estimation:

• CAPM provides a framework for estimating the expected return on an investment. It takes into account the risk-free rate, the asset’s beta, and the expected market return. This information is valuable for investors and financial analysts in making informed decisions about whether an investment is likely to provide an adequate return based on its risk profile.

2. Cost of Capital:

• Businesses use CAPM to estimate their cost of equity, which is a critical component in determining the overall cost of capital. This cost of capital is essential for evaluating the feasibility of new projects and making capital budgeting decisions.

3. Portfolio Management:

• CAPM is a fundamental tool in portfolio management. Investors use it to assess the expected return and risk of a portfolio of assets. By considering the CAPM-derived expected returns and risk measures of individual assets, investors can create well-diversified portfolios that aim to optimize the risk-return tradeoff.

4. Valuation of Securities:

• CAPM is used in the valuation of individual securities. Analysts may use the model to determine the appropriate discount rate for valuing a company’s stock, particularly when estimating the cost of equity.

5. Asset Pricing Theory:

• CAPM is a central component of asset pricing theory. It provides a foundation for understanding the relationship between risk and expected return in financial markets. The model has played a crucial role in the development of modern finance theories.

6. Risk Management:

• CAPM helps investors assess the risk associated with different investments. It allows for a standardized measure of risk through the use of beta, which indicates how much the price of an asset is expected to move in relation to the overall market.

7. Capital Budgeting:

• In corporate finance, CAPM is used in capital budgeting decisions. It helps evaluate the attractiveness of potential investments by providing a measure of the return required by investors given the risk profile of the investment.

While CAPM is a widely used and influential model, it’s essential to note that it makes simplifying assumptions (such as constant expected returns and linear relationships) that may not fully capture the complexities of real-world financial markets. Consequently, it is often used in conjunction with other valuation models and risk assessment techniques.