CAPM, or the capital asset pricing model, is a type of financial model used in corporate finance to describe the relationship between the risk of a security (such as a stock) and the market as a whole. Investment bankers often use this model to analyze individual stocks or whole portfolios, and CAPM forms a foundation for other important calculations in corporate finance.
In this guide, we’ll go over:
- CAPM Definition
- CAPM Formula
- Shortcomings of the CAPM
- Showing CAPM Skills on Your Resume
- Similar Investing Skills
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The capital asset pricing model (CAPM) calculates expected returns from an investment and can be used to determine prices for individual securities, such as stocks. As a core part of corporate finance and investment banking, CAPM looks at the relationship between the investment’s riskiness and the inherent risks of the market at large.
CAPM was primarily created to measure systemic risk, or risk that a company or individual can’t account for or avoid. Systemic risk includes risk from interest rates, exchange rates, and inflation. Systemic risk is also caused by the fact that prices on the market tend to move together — if the market as a whole is doing well, even share prices for less-than-perfect companies typically do well.
Investors need compensation for this systematic risk through risk premiums. For example, if an investor puts money into a very risky stock, they need high risk premiums (a high return rate) in exchange. The CAPM helps investors determine how much they can expect to get back for investments, especially risky ones.
Who Uses the Capital Asset Pricing Model?
Many areas of the finance industry use CAPM. For example, investment bankers and investors may use this model to determine if an investment is worth the risk or to analyze how well an investment portfolio will perform.
The capital asset pricing model is sometimes used to help calculate other important metrics in finance, too. For example, CAPM ultimately can calculate the cost of equity (or shares of a company), which is essential for figuring out a company’s WACC, or weighted average cost of capital — how much the company pays to finance its assets.
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The capital asset pricing model equation looks like:
Ra = Rrf + [Ba x (Rm – Rrf)]
In this formula:
- Ra is the expected rate of return on the investment (or asset, hence the “a”)
- Rrf is the risk-free rate of return
- Ba is the beta (𝛃) of the investment (or asset, hence the “a”)
- Rm is the expected rate of return of the market (hence the “m”)
- This portion of the formula — (Rm – Rrf) — is referred to as the risk premium.
Components of the CAPM Formula
Expected Rate of Return on Investment
An asset or investment’s expected rate of return is how much the investor should make over the investment’s lifetime. In the CAPM formula, the expected rate of return is based on the other factors within the equation, like the stock’s beta and the return rate of the market.
Risk-Free Rate of Return
In theory, certain securities (stocks or bonds) have no risks. In the U.S., the risk-free rate of return is usually based on the return rate for a three-month treasury bill or 10-year government bonds. Using securities issued by the government is the baseline for risk-free rates because the U.S. government is unlikely to default on payment. No default in payments means these investments pose minimal risk to investors.
Put simply, the beta of a stock, asset, or investment measures how risky it is. The beta is a numerical representation of how volatile the stock’s price is compared to the market. Beta can also be thought of as the stock’s sensitivity to market changes — a sensitive stock will be very volatile (have a high beta), while a more steadfast stock will not react to market changes as much (have a low beta).
A beta of 1 means the stock is equally as unsteady as the market, while a beta below 1 signifies the stock is more stable than the market and holds less risk. However, stocks with betas above 1 are more volatile than the market. Stocks can have negative betas, too, but a negative beta means the stock has an inverse relationship with the market. For example, if the market is up 15%, but a stock has a beta of -0.5, the stock will return -5% despite the market being up as a whole.
A high or low beta is not necessarily good or bad. Instead, stocks with high betas are riskier but may also have higher returns. Lower betas are less risky but may offer lower returns. Negative betas are common for certain types of stock options and have their pros and cons.
Expected Rate of Return of the Market
The market’s rate of return is the average amount investors can expect to make from investments in the market as a whole, based on historical data.
In the capital asset pricing model, the risk premium (also called the market risk premium) is the difference between the risk-free rate of return and the returns on a specific stock or investment. Essentially, this is how much the investor is rewarded for taking a risk rather than investing in lower- or zero-risk options, like government bonds. If a stock, asset, or investment is very risky, it will have a high risk premium, meaning the investor should see a higher reward for their risk.
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Using the capital asset pricing model formula, we can calculate the expected rate of return on a stock. First, we need to set some assumptions and gather some details:
- The stock exclusively trades in the U.S. through the New York Stock Exchange (NYSE) — this is important because exchange rates and international investment risk change many aspects of this formula.
- The beta for our imaginary stock is 1.75 — highly volatile but potentially a higher chance of reward.
- Based on current U.S. 10-year treasury bond returns, the risk-free rate is 3.4%.
- The average market risk premium for stocks traded in the U.S. is 7.5%.
Using the CAPM equation, we have the following:
Ra = 3.4% (risk-free rate) + (1.75 (beta) x 7.5% (risk premium))
Our expected rate of return is: 16.5%
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Shortcomings of the CAPM
The capital asset pricing model is widely used despite having some key flaws.
First, CAPM makes some somewhat unreasonable assumptions. For example, the formula only works if we assume that the market is dominated exclusively by rational actors who make decisions that only prioritize returns on investments. This, of course, isn’t always true. Additionally, the model assumes that every actor in the market is acting on the same information. In reality, relevant information is not equally distributed to the public, so certain actors may make decisions based on information others don’t have.
Another core problem with the capital asset pricing model is its use of beta as a core part of the formula. Beta inherently implies that any positive or negative changes in a stock’s price indicate volatility and sensitivity to the market. However, a stock’s price may change for reasons other than the market. Stocks may rise or fall in price for intentional reasons rather than simple volatility.
Lastly, CAPM relies only on historical data. This is an issue with many financial models and a problem that is nearly impossible to avoid. Ultimately, in the capital asset pricing model, a stock’s historical price changes are not enough to determine the overall risk of investment. In order to truly understand the risk of an investment, other aspects need to be considered, such as economic conditions, the stock’s industry and competitors, and internal and external actions of the company itself. For this reason, the CAPM is only one tool investors use when analyzing investment options,
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Showing CAPM Skills on Your Resume
You can bring capital asset market pricing skills into your resume in two key areas. The first is in the description section of prior work or internship experience. For example, if you had a job or a project as an intern where you used the CAPM, you could say something like:
- Determined the expected return rate for clients’ portfolios using financial models, such as CAPM.
However, you can also include CAPM as part of the skills section on your resume. For example, you could have a line in the skills section like:
- Financial modeling, including CAPM, DCF valuation, and LBO modeling.
If you don’t have prior internship or work experience using the capital asset pricing model, you can use your cover letter to discuss your familiarity with this model through coursework or independent study.
>>MORE: Find out what other skills you need for your investment banking resume.
Similar Investing Skills
Investment bankers and other finance professionals often use financial modeling skills in their day-to-day work. However, it is also important for these professionals to have skills in looking at the relationships between various financial aspects of a business, internally and externally. Some of these skills include:
- Knowing how to calculate and use the weighted average cost of capital (WACC)
- Understanding how to complete a comparable company analysis
- Ability to evaluate investments using discounted cash flow (DCF) valuations
- Knowledge of the formula and uses for EBITDA (earnings before interest, taxes, depreciation, and amortization)
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