CAPM is an acronym for the capital asset pricing model. The CAPM model is used to determine the value of an asset; one of the major assumptions of the model is that markets operate efficiently. The CAPM formula assumes that the asset will be added to a well-diversified portfolio. This means that the pricing does not take into account any unique risk. There are three basic forms of market efficiency: weak, semi-strong, and strong.
Time Value of Money
Time value of money is the first factor built in to the CAPM equation. The world’s top economies and their central banks try to maintain a level of inflation of around 3 percent. When governments issue bonds, they must offer a return to the investor. U.S. government-issued bonds are considered to be risk-free. However, due to the minimal risk, the return is not as high. Money can be invested at a guaranteed rate of return--the risk-free rate--and be worth more than the future. Incorporating this rate of return into the CAPM equation addresses the issue of the time value of money.
Each individual security is given a risk rating relative to the market. This variable is denoted as B, or beta. The market beta is equal to one. Any security less risky than the market portfolio has a beta between zero and one. Any security that is riskier than the market portfolio has a beta greater than one. Additionally, the market has an expected return. The expected return on the market in excess of the risk-free rate of return is known as the market risk premium.
To calculate the adequate return in excess of the risk-free rate for an individual security, the market risk premium is multiplied by beta.
Market efficiency is a concept that explains how accurately stock prices reflect the information available to the public. The first form of market efficiency is weak. Weak market efficiency claims that stock prices reflect all information from the past that has been publicly made available to the company. The semi-strong form takes the information included in the weak form, and then adds that the markets will respond instantaneously to current events and information. Strong form includes the information from the semi-strong form, but then goes on to claim prices also reflect insider information not available to the public.
The CAPM Equation
All three of these factors come together to form the capital asset pricing model. To recap, the variables in the model include the risk-free rate of return, the expected return on the market portfolio, and beta: the relative risk of an individual security in relation to the risk of the market portfolio.
Expected return on a security equals the risk-free rate plus B (the expected market portfolio return minus the risk-free rate).