In the last tutorial, we discussed factor investing and its evolution from CAPM (Capital Asset Pricing Model). In this article, we will discuss more about CAPM and why it so widely used by fund managers across the globe.
According to this theory, diversification helps us mitigate risk. But no matter how much we diversify, it is impossible to eliminate risk completely. This is where CAPM comes into picture. It helps us calculate the risk on investment and the expected return on it.
History:
The CAPM was the work of financial economist and Nobel laureate in economics William Sharpe which he described in his 1970 book "Portfolio Theory and Capital Markets." His model starts with the idea that individual investment contains two types of risk:
Systematic Risk – It is the risk that cannot be diversified. Risk that affects the portfolio due to the prevailing market conditions such as interest rate risk, recession, wars, etc. are few examples of systematic risk.
Unsystematic Risk – It is a risk that can be diversified by adding different stocks in the portfolio. In more technical terms, it represents the component of stock’s return that is not correlated with general market moves. It is also known as ‘specific risk’.
You will get more details about systematic and unsystematic risk under the modern portfolio theory.
Formula:
ra=rf + β(rm – rf)
ra= expected market return
rf = risk free rate
β = beta
rm = expected market return
(rm – rf) = equity risk premium
Risk free rate: The risk-free rate of return is the theoretical rate of return of an investment with zero risk. Normally, government securities interest rate is taken as a risk-free rate. To break it down, it is the minimum return that investors expects to get when he does not take any additional risk. In practicality, there is no return without any risk.
Market Risk Premium: Market risk premium is the difference between the expected market return and the risk free rate. It is also known as equity premium, risk premium or the market premium.
Expected market return: It is the return that one expects on the investment. Generally the expected return is calculated based on historical data and is not guaranteed.
There are three distinct concepts to the market risk premium:
• Historical Market Risk Premium: The historical differential return of market over government bonds etc.
• Required market risk premium: The return of the portfolio that market expects over the risk-free rate
• Expected market risk premium: Expected return of markets over the treasury bonds.
Beta: Beta measures the sensitivity of a stock or a portfolio to market as a whole. In other terms, it is a measure of volatility or it is the systematic risk. It is calculated using regression analysis.
Beta of 1 represents that security is in line with market, less than 1 indicates less volatility while more than 1 indicates that the stock is more volatile than the market.
Beta when compared with equity risk premium shows how much more return investors get for taking on additional risk.
For example, if beta is 2, risk free rate is 3% and market risk premium is 4%, then stocks excess return is (2% * 4%) 8% while the expected rate of return is 8% + 3% which is 11%.
Conclusion:
The model tells a simple theory of how investing in a riskier stock on an average will help the investor earn more than the less risky stock. No wonder it is so widely popular. Though there are many who doubt the model, as discussed in our factor investing tutorial, this model is widely used in investment community, especially by fund managers.
It helps fund managers distinguish between the volatility of stocks and thereby help them customize the clients profile as per client’s needs.