CAPM - Capital Asset Pricing Model

Go to CAPM Analysis Tools

CAPM, as any other model, has its area of applicability. This area is defined by simplifications, accepted during model creation. Such assumptions filter out unnecessary complexities and allow effective application of mathematical core, which translates empirical observations from area of sensation to the area of knowledge. Therefore, when creating CAPM, the following assumptions have been made:

• Investor is guided by only two factors - yield and risk;
• Investors operate rationally - with the same expected yield they prefer an asset with the minimal risk (or an effective portfolio);
• All investors have the same investment timeframe;
• Investors evaluate asset key parameters in identical manner;
• Individual investor behavior does not influence equal prices of an asset;
• There are no operational costs or hindrances, preventing free supply and demand of assets.

Discussions as to how feasible these preconditions are in reality and, accordingly, how effective application of this model could be, are going on up to date. For the sake of fairness, it is necessary to point out that these discussions have been going on over the entire lifetime of the model - from the very moment of its development. However, the following three facts persist:

• The model is alive, despite of its age;
• One of the model developers is a Nobel prize winner;
• The model is obligatory in all solid financial courses.

Now let's proceed from theoretical reasoning to practice. What does the model actually represent?

Figure 1. Graphic presentation of CAPM model.
"Beta" (β) an asset market risk parameter, represents straight-line inclination degree.
E is average "residual" yield, describing an average asset yield deviation from "fair" yield as shown by the central line.

To create a graphic interpretation of the model, plot on a plane points, whose horizontal coordinates represent a market portfolio yield, while the vertical ones are the appropriate asset yield. One of the major stock indices, for example S&P500, is taken as market portfolio. Viewing the formed cloud of points closely, one can note that it is extended along some straight line - that of characteristic line of the given security.

The main assertion of the model is that price yield of a selected asset (or portfolio) is directly proportional to price yield of the market portfolio.

The two important parameters describing a concrete asset, are:

• "Beta" parameter, describing angle of straight line inclination;
• E parameter, describing degree of cloud concentration along the straight line.

"Beta" is a parameter of asset sensitivity to changes in market portfolio price. If, for example, "beta" is equal to 1.5, it means that when the market portfolio changes by +1%, the asset price will change by +1.5%. Assets that are more sensitive to the market are matched with greater "beta" values. This parameter is responsible for systematic (or market) asset risk, which is impossible to diversify.

E parameter corresponds to "residual" yield dependent on specificity of a concrete asset. It is matched with non-systematic risk, which could be reduced by creation of asset portfolio.

To analyze stocks traded at NYSE, NASDAQ, and AMEX, we present you with a family of products based on CAPM model. All of them are executed at top mathematical level. In particular, there are few products, where you can find an error of "beta" parameter statistical evaluation, but it plays an important role. Supose you want to select an asset with "beta" value higher than 1. You have two different assets with an identical "beta" evaluation equal to 1.3, but one asset has "beta" definition error of 0.1, while the other one 0.6. Which one will you prefer?

Services offered within the CAPM model framework:

Go to CAPM Analysis Tools