The Capital Asset Pricing Model (CAPM): A Framework for Quantifying Expected Returns

The Capital Asset Pricing Model (or CAPM for short) is widely used in the investment community to quantify the return investors should expect for a given security. CAPM was developed by legendary financial economist William Sharpe (does the Sharpe ratio sound familiar?) in 1970.

CAPM Formula

The CAPM formula describes the relationship between risk and expected return for a given security.

The yield of the 10-year Treasury note is typically used for the risk-free rate.

Beta essentially measures how an individual asset moves, on average, in relation to the market. For example, if an asset has a beta of 1.0, then when the market increases by 1%, we can expect the asset to increase by 1%, on average. If beta was 2.0, then the asset should increase by 2%, on average. If beta was -1.0, then the asset should decline by 1% when the market increases by 1%.

As an example, let's say the risk-free rate is 2%, the expected market return is 6%, and a security's beta is 1.0. Then according to CAPM, the expected return of this security would be 6%. This certainly makes sense as a security with a beta of 1.0 would be expected to achieve market returns by default.

Pitfalls

The primary issue with CAPM is the use of beta. By definition, beta is a backward-looking metric. That is, beta is calculated by using the historical returns of the market and the security in question. And, of course, we all know that past performance does not guarantee future results.

Nevertheless, CAPM is still widely used as it does provide a way to ballpark expected returns. And more importantly, CAPM forms the foundation for many other important metrics, such as alpha and Sharpe ratio (more on those later).

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