CAPM and market efficiency
The capital asset pricing model links an investment's expected return to its systematic risk, measured by beta.
Beta
Beta measures an asset's sensitivity to market movements, its systematic risk. The market has a beta of 1. A stock with beta 1.5 tends to rise or fall 1.5% when the market moves 1%; a beta of 0.5 means half the market's movement. Utilities often have low betas; technology stocks often high ones.
The CAPM
The capital asset pricing model (CAPM), developed in the 1960s by William Sharpe and others, says expected return = risk-free rate + beta x market risk premium: \(E(R_i) = R_f + \beta_i (E(R_m) - R_f)\). With a 4% risk-free rate, a 6% market risk premium, and beta 1.2, expected return is 4 + 1.2 x 6 = 11.2%.
E(R_i) = R_f + \beta_i(E(R_m) - R_f)The security market line
Plotting expected return against beta gives the security market line (SML). Assets plotting above it offer more return than their risk warrants (undervalued); those below it offer less (overvalued). In equilibrium, all assets should lie on the line.
Why only systematic risk is rewarded
Because investors can diversify away specific risk at little cost, the market rewards only systematic risk. Holding a single risky stock exposes an investor to extra risk without extra expected return, a key insight of CAPM.
Using CAPM
Companies use CAPM to estimate their cost of equity for capital budgeting and valuation. Analysts estimate beta from historical returns, choose a risk-free rate (often a government bond yield), and estimate the market risk premium, each a source of uncertainty.
Criticisms and alternatives
Empirical tests found CAPM does not fully explain returns. Eugene Fama and Kenneth French's three-factor model (1993) added size and value factors, and later models added profitability and investment factors. Arbitrage pricing theory allows multiple risk factors. CAPM remains widely taught and used for its simplicity.
Market efficiency and anomalies
The efficient market hypothesis has weak, semi-strong, and strong forms: prices reflect past prices, all public information, or all information including private, respectively. Anomalies such as momentum and post-earnings drift challenge strict efficiency, and behavioural finance studies how psychology affects prices, yet consistently beating the market after costs remains rare.
Worked example
A stock has a beta of 0.8. The risk-free rate is 3.5% and the market risk premium is 5.5%. CAPM expected return = 3.5 + 0.8 x 5.5 = 7.9%. If analysts expect the stock to return 10%, it plots above the SML and may be undervalued, assuming the inputs are correct.
Key takeaways
Beta measures systematic risk; the market's beta is 1. CAPM: expected return = risk-free rate + beta x market risk premium. The security market line plots expected return against beta; assets above it may be undervalued. Only systematic risk is rewarded because specific risk can be diversified. Firms use CAPM to estimate cost of equity. Multi-factor models such as Fama-French add size and value factors. Markets are largely efficient, though anomalies exist.
Flashcard
Sensitivity to market movements
Check your understanding
The risk-free rate is 4%, the market risk premium is 5%, and a stock's beta is 1.4. What is its CAPM expected return?