The value of an asset or group of assets is a central concept in investments and is crucial to an investor’s success. Some investment tools, like derivatives, even derive value directly from assets. The Capital Asset Pricing Model is a way of calculating the rate of return for an asset given a variety of different factors.
The Capital Asset Pricing Model was introduced in the 1960s by four different men, based on earlier research of Harry Markowitz. William Forsyth Sharpe, Merton Miller, and Markowitz were awarded the Nobel Memorial Prize in Economics in 1990 for their efforts and research in developing the Capital Asset Pricing Model. Their explorations in financial economics have a timeless legacy and are still used regularly by financial analysts and planners today.
The Capital Asset Pricing Model is a way of valuing a particular security. It can also be used to value an entire portfolio. One facet of the formula of the model is the security market line, or SML, a line graphed using the risk-free interest rate as the Y-intercept and a slope of the market risk premium. Essentially, the SML is a representation of the opportunity cost of an investment, which is a significant factor in the Capital Asset Pricing Model when evaluating individual securities. The SML is specifically used to calculate the reward-to-risk ratio, a valuable way of evaluating how likely a security is to perform as anticipated in a particular market. The SML examines the ratio of risk-free return to total asset return.
In all, the Capital Asset Pricing Model evaluates the expected return, indicated by E(Ri), the risk-free rate of interest, indicated by Rf, the sensitivity of the rate of return in relation to market returns, indicated by Beta, and the expected rate of return for the market as a whole, represented by E(Rm). The model also looks at market premium, which is the market rate of return less the risk-free rate of interest, and risk premium.
Although it sounds complicated, the Capital Asset Pricing Model takes into account very basic concepts, like individual and market rates of return, a particular reward-to-risk ratio, interest rates, and market and risk premiums. Individually, each of these factors is clearly defined and easily understandable. When combined, they can predict the values of individual assets or a portfolio of assets.
Both investors and financial analysts can see great use in the Capital Asset Pricing Model. Investors who understand the financial market can use the model to evaluate their own assets to estimate the future worth of their portfolios, and make informed decisions about how to proceed with their personal investments. Financial analysts use the Capital Asset Pricing Model to decide what securities to buy or sell for their clients or to help clients understand the estimated future performance of their portfolios. This is very useful in helping asset management firms both keep clients and gain new ones.
As the Capital Asset Pricing Model is very complicated and designed for those well versed in economics and finance, it is primarily used by professionals with regards to asset and portfolio valuation. There are many assumptions and several problematic factors analysts must take into account when using the model, making it useful but imperfect. With market conditions subject to such unpredictable short-term fluctuations, there are many factors difficult to estimate. However, this does not diminish its use as a valuable tool for long-term valuation of both individual securities and portfolios.
Steve Yates is a freelance writer based in Richmond, Virginia. Yates enjoys writing about taxation, finance, corporate law, banking, econometrics, and other kindred topics; to educate yourself about taxation view the resources at R&G Brenner Taxes.