Capital Asset Pricing Model (CAPM) – Calculation, Advantages, Problems

In finance and investment, there's one model that keeps coming up, no matter where you are, that is CAPM. Whether you are a finance student, a beginner investor, or preparing for a CFA, MBA or CA, getting a good understanding of CAPM is essential. This blog seeks to give the CAPM model explained most simply and clearly as possible. Scroll down to know about CAPM, CAPM Formula, CAPM Calculation, advantages and disadvantages of CAPM and Examples of CAPM.

What is the Capital Asset Pricing Model (CAPM)?

CAPM is a financial model that is used to forecast the expected return of an investment(like a stock or a portfolio of stocks) in relation to the risk involved.

CAPM is a function of the risk in the investment. Essentially, it is used to provide expected returns of assets. This model provides a direct relationship function where, for each investment, there is a level of risk and a potential return. This relationship shows that there is a potential return that can be earned from riskier investments.

Why Is CAPM Important?

Investors appreciate CAPM because it:

- Helps analyse and determine if a stock is worth buying.

- Assists companies in estimating their cost of equity.

- Allows portfolio managers to make comparisons of their investments.

- Helps students comprehend the risk-return relationship.

As a result, CAPM is a foundational principle in almost every finance class.

Core Idea Behind CAPM (Simple Logic)

The logic behind the CAPM framework is:

- Investors expect, at a minimum, a risk-free return.

- The greater the risk, the greater the potential return.

- Only the general market risk is relevant; company-specific risk does not matter.

CAPM is predicated on the assumption that investors act rationally and that the markets function efficiently.

CAPM Formula Explained

The pinnacle of the logic is the CAPM formula:

 Expected Return = Risk-Free Return + Beta x (Expected Market Return - Risk-Free Return)

Which is mathematically represented as:

E(R) = Rf + β × (Rm - Rf).

Now let's clarify each of the terms.

 

 

Meaning of Each Term in the CAPM Formula

1. Risk-Free Rate (Rf)

- Return from a risk-free investment

- In India → Government bonds (G-Sec)

- Example: 7%

2. Market Return (Rm)

- Average return of the overall market

- Example: NIFTY or Sensex long-term return

- Example: 14%

3. Beta (β)

- Measures volatility or risk

- Beta = 1 → same risk as market

- Beta  1 → more risky than market

- Beta < 1 → less risky than market

4. Market Risk Premium (Rm − Rf)

- Extra return investors expect for taking market risk

CAPM Calculation (Step-by-Step Example)

Let's do a simple CAPM calculation.

Given:

- Risk-Free Rate (Rf) = 6%

- Market Return (Rm) = 14%

- Beta of stock = 1.2

Step 1: Market Risk Premium

14% − 6% = 8%

Step 2: Multiply by Beta

8% × 1.2 = 9.6%

Step 3: Add Risk-Free Rate

6% + 9.6% = 15.6%

Expected Return = 15.6%

This means:

If the stock gives less than 15.6%, it may not be worth the risk.

What Does CAPM Tell Investors?

Investors can use CAPM to determine:

Any stocks currently under- or overpriced?

Possible return correlated to the risk involved?

Investment opportunities: Should I pursue or ignore?

This is the reason CAPM is popular with valuation models.

CAPM and Cost of Equity

Businesses apply CAPM to determine the cost of equity:

• Shareholders expect a return.

• It is used in equity valuation (DCF model).

• Cost of Equity = Expected Return From CAPM.

• This is the reason CAPM is integral to corporate finance.
  
  

CAPM Model Explained with Real-Life Example

You could think of it this way:

A Bank FD (fixed deposit) gives you 6% (risk-free).

Currently, the market is giving 14%.

A risky stock is expected to return more than 14%.

CAPM determines how much more.

This illustrates the purpose of the capital asset pricing model.

CAPM Advantages (Why It Is Popular)

Let’s explore CAPM advantages.

1. Simple and Easy to Use

• CAPM is beginner-friendly.

• All it takes is three inputs:

• Risk-free rate

• Beta

• Market return.
  
  

2. Focus on Systematic Risk

CAPM takes a unique approach by focusing on market risk alone. This is the type of risk that cannot be diversified.

3. Widely Accepted Model

Being Used By:

• Analysts

• Fund managers

• Corporations

• Scholars.

 

4. Useful for Valuation

Calculates the Cost of equity and Discount rate in DCF.

5. Logical Risk-Return Relationship

Higher risk → higher return expected.

This makes the model easy to understand and usable.

 

 

Limitations of the Model (Problems of the Model)

Even with general acceptance, the limitations of the model should be known.

1. Unrealistic Assumptions

Model assumes:

• No tax.

• No costs for trading.

• No imperfections in the system.

• This is never the case.
  
  

2. Beta is not Static

• Beta is not constant.

• The previous beta does not indicate the level of risk for the future.

• This leads to inaccuracy.
  
  

3. Estimating Market Return is Complex

• A variety of analysts for a single market.

• Widely varied results.
  
  

4. Other Risk Factors Ignored

• The model ignores every risk factor other than market risk.

• No consideration of size risk.

• No consideration of value risk.

• No consideration of momentum.

• This is why multi-factor models exist.
  
  

Legislative Bonds And Their Risks

Deficient government bonds carry with them certain risks, including:

• Risk of inflation

• Risk of interest.

Capital Asset Pricing Model in Comparison to Investments in the Real World

In the real world:

• CAPM helps provide a base case.

• Users are encouraged to use some creative thought to make refinements.

• CAPM is integrated with other modelling systems.

• Ultimately, CAPM represents a marginally helpful tool.
  
  

CAPM in Contrast with Other Models in a Tabular Form

Model	Factors Used
CAPM	Market risk only
Fama-French	Size + Value
APT	Multiple macro factors

In terms of simplicity, this is CAPM, while the rest are more sophisticated.

CAPM Application Cases

A case scenario when you can apply CAPM includes the following:

• You need an expected return in a short duration.

• You are undertaking a company valuation.

• You are in the process of understanding the fundamentals of finance.

• You require the equity cost.

• Short-term trading CAPM without using other tools can result in losses.

For this example, we can conclusively state CAPM in a single sentence

CAPM determines the return expected by an investor when they are subjected to risks associated with the market.

CAPM Mistakes (Common Ones)

• Some users input the wrong beta.

• Some users input an unrealistic market return.

• Some users neglect the CAPM limitations.

• Some users do not treat CAPM as an estimate.

• It is important to note that CAPM is a subjective estimate rather than an objective guarantee.
  
  

Is CAPM Still Useful?

Definitely yes, because of the following reasons:

- CAPM sets the foundation of modern finance

- CAPM is still taught and used in business valuation

- CAPM easily explains the risk vs. return thinking

However, CAPM should be used carefully.

Final Revision of CAPM

- CAPM explains the relationship of risk vs. return.

- CAPM computes the expected return of an asset.

- CAPM computation is easy.

- CAPM is very popular because of its benefits.

- CAPM is a reminder that no model is perfect.

 

Conclusion

The CAPM model discussed in this blog is one of the finance concepts that should never be forgotten. CAPM is not perfect, contains a lot of assumptions, but gives a concrete foundation of risk and return.

CAPM is a strong foundation for students.

CAPM gives assurance for logical thinking for investors.

CAPM provides an estimation for the cost of equity for firms.

Summary of Key Points

CAPM teaches investors that it is out of the question to make returns, but explains the bare minimum return an investor should expect for the amount of risk taken.

 

DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.