Benefits and Limitations of CAPM
CAPM is the tool to measure the relationship between required return and risk of new investment. This model builds on the connection between asset beta, risk-free, and equity risk premium. A risk-free rate is a financial instrument that almost has no risk attached. It refers to treasury bills issued by the US government and it almost has zero chance that the US government going to bankrupt and default on the bill.
This model suggests that investors will reward in both risk and return (time value of money) and they are interconnected. Risk-free return plus risk premium is equal to the expected return on the security.
CAPM calculates the expected return from the new investment. It takes into account the Beta, risk-free rate, and the market risk premium.
Beta is the tool to measure the change in investment return compared to the entire market. It compares the investment risk to the market risk. A company that has a big beta, has greater risk and greater return compared to the market.
- Beta = 1: it means that the investment’s return will change to align with the market. If the market increase, the investment return will increase by the exact percentage.
- Beta <1: The return of an investment will move along the market but the percentage change will be less than the market.
- Beta >1: The return still moves along the market and it increases or decreases more than the market.
- Beta<0: It means the investment return will move on the opposite side from the entire market.
Market Risk Premium is the difference between the market return and the risk-free rate. It measures the additional return that the market provides in exchange for the extra risk. The risk-free rate refers to the safest investment such as a government bond.
CAPM (Re) = Rf + B(Rm-Rf)
- CAPM (Re): Cost of equity
- B: Beta
- Rm: Market Risk Premium
- Rf: Risk-Free Rate
- Investors risk-averse: We assume that the investors are risk-averse, they are looking for low-risk investments even the return is not high. They prefer a safe investment over a high return.
- Free access to all available information: We assume that every investor will be able to access all available information for free. In reality, not everyone has enough time and energy to chase all kinds of information even if it is free.
- There are transaction costs and taxes: The CAPM formula does not take into account the tax and transaction cost while it is very normal in real life.
- Perfect competition: We assume the market is perfectly competitive, there is no investor or someone who could manipulate the market.
Benefit of CAPM
- Easy to use: Th concept is straightforward forward which everyone can use and apply in real life. It is calculated and use in many capital markets to estimate a proper rate of return.
- Account for systematic risk: Different from other tools, CAPM takes into account the systematic risk which is unforeseen and cannot be ignored.
- Diversify: The investor as well as the market like to diversify their portfolio to reduce the risk.
Limitation of CAPM
- Risk-Free Rate: CAPM use US government bond as the risk-free rate. The problem is the return on this security change on a daily basis so it will impact the whole CAPM calculation. Moreover, the term risk-free rate does not exist in real life. Even if we use the government bond, there are still risks involved to some extent. The risk is very low, but it is not really zero.
- Ability to borrow: CAPM assumes that the investors can borrow and lend at a risk-free rate which is not happening in real life. Risk-free rates are mainly borrowed by the government due to the nature of low risk.
- Return on Market: the return on market as a whole is not always positive. In an economic downturn, the return of the whole market will be negative.
- Unrealistic assumption: Many issues with CAPM is an unrealistic assumption, an assumption that never happens in real life.
- Beta calculation: Beta is the relationship between investment and the market movement. It helps investors to make investments aligned with the market or the opposite. However, the beta calculation is not perfect. It does not really tell the exact story.