Definition of 'Risk-Free Asset'

An asset which has a certain future return. Treasuries (especially T-bills) are considered to be riskfree because they are backed by the U.S. government.

Investopedia explains 'Risk-Free Asset'

Because they are so safe, the return on risk-free assets is very close to the current interest rate. Many academics say that there is no such thing as a risk-free asset because all financial assets carry some degree of risk. Technically, this may be correct. However, the level of risk is so small that, for the average investor, it is OK to consider U.S. Treasuries or Treasuries from stable Western governments to be risk-free.

The Capital Asset Pricing Model: An Overview

November 24 2010| Filed Under Capital Market, Economics, Financial Theory, Portfolio Management, Risk Management No matter how much we diversify our investments, it's impossible to get rid of all the risk. As investors, we deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM) helps us to calculate investment risk and what return on investment we should expect. Here we look at the formula behind the model, the evidence for and against the accuracy of CAPM, and what CAPM means to the average investor. Birth of a Model The capital asset pricing model was the work of financial economist (and, later,

Nobel laureate in economics) William Sharpe, set out in his 1970 book "Portfolio Theory And Capital Markets." His model starts with the idea that individual investment contains two types of risk: 1. Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks. 2. Unsystematic Risk - Also known as "specific risk," this risk is specific to individual stocks and can be diversified away as the investor increases the number of stocks in his or her portfolio. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves. Modern portfolio theory shows that specific risk can be removed through diversification. The trouble is that diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares in the stock market can't eliminate that risk. Therefore, when calculating a deserved return, systematic risk is what plagues investors most. CAPM, therefore, evolved as a way to measure this systematic risk. (To learn more, see Modern Portfolio Theory: An Overview.) The Formula Sharpe found that the return on an individual stock, or a portfolio of stocks, should equal its cost of capital. The standard formula remains the CAPM, which describes the relationship between risk and expected return. Here is the formula:

CAPM's starting point is the risk-free rate - typically a 10-year government bond yield. To this is added a premium that equity investors demand to compensate

them for the extra risk they accept. This equity market premium consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta." Beta According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's relative volatility - that is, it shows how much the price of a particular stock jumps up and down compared with how much the stock market as a whole jumps up and down. If a share price moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10%, and fall by 15% if the market fell by 10%. (For further reading, see Beta: Gauging Price Fluctuations and Beta: Know The Risk.) Beta is found by statistical analysis of individual, daily share price returns, in comparison with the market's daily returns over precisely the same period. In their classic 1972 study titled "The Capital Asset Pricing Model: Some Empirical Tests," financial economists Fischer Black, Michael C. Jensen and Myron Scholes confirmed a linear relationship between the financial returns of stock portfolios and their betas. They studied the price movements of the stocks on the New York Stock Exchange between 1931 and 1965.

Beta, compared with the equity risk premium, shows the amount of compensation

equity investors need for taking on additional risk. If the stock's beta is 2.0, the risk-free rate is 3% and the market rate of return is 7%, the market's excess return is 4% (7% - 3%). Accordingly, the stock's excess return is 8% (2 X 4%, multiplying market return by the beta), and the stock's total required return is 11% (8% + 3%, the stock's excess return plus the risk-free rate). What this shows is that a riskier investment should earn a premium over the riskfree rate - the amount over the risk-free rate is calculated by the equity market premium multiplied by its beta. In other words, it's possible, by knowing the individual parts of the CAPM, to gauge whether or not the current price of a stock is consistent with its likely return - that is, whether or not the investment is a bargain or too expensive. What CAPM Means for You This model presents a very simple theory that delivers a simple result. The theory says that the only reason an investor should earn more, on average, by investing in one stock rather than another is that one stock is riskier. Not surprisingly, the model has come to dominate modern financial theory. But does it really work? It's not entirely clear. The big sticking point is beta. When professors Eugene Fama and Kenneth French looked at share returns on the New York Stock Exchange, the American Stock Exchange and Nasdaq between 1963 and 1990, they found that differences in betas over that lengthy period did not explain the performance of different stocks. The linear relationship between beta and individual stock returns also breaks down over shorter periods of time. These findings seem to suggest that CAPM may be wrong.

While some studies raise doubts about CAPM's validity, the model is still widely used in the investment community. Although it is difficult to predict from beta how individual stocks might react to particular movements, investors can probably safely deduce that a portfolio of high-beta stocks will move more than the market in either direction, and a portfolio of low-beta stocks will move less than the market. This is important for investors - especially fund managers - because they may be unwilling to or prevented from holding cash if they feel that the market is likely to fall. If so, they can hold low-beta stocks instead. Investors can tailor a portfolio to their specific risk-return requirements, aiming to hold securities with betas in excess of 1 while the market is rising, and securities with betas of less than 1 when the market is falling. Not surprisingly, CAPM contributed to the rise in use of indexing - assembling a portfolio of shares to mimic a particular market - by risk averse investors. This is largely due to CAPM's message that it is only possible to earn higher returns than those of the market as a whole by taking on higher risk (beta). (To learn more, see The Lowdown On Index Funds.) Conclusion The capital asset pricing model is by no means a perfect theory. But the spirit of

CAPM is correct. It provides a usable measure of risk that helps investors determine what return they deserve for putting their money at risk. To learn more, see Achieving Better Returns In Your Portfolio.

Tricks of the Trade As experts warn, CAPM is only a simple calculation built on historical data of market and stock prices. It does not express anything about the company whose stock is being analyzed. For example, renowned investor Warren Buffett has pointed out that if a company making Barbie dolls has the same beta as one making pet rocks, CAPM holds that one investment is as good as the other. Clearly, this is a risky tenet. While high returns might be received from stocks with high beta shares, there is no guarantee that their respective CAPM return will be realized (a reason why beta is defined as a measure of risk rather than an indication of high return). The beta parameter itself is historical data and may not reflect future results. The data for beta values are typically gathered over several years, and experts recommend that only long-term investors should rely on the CAPM formula. Over longer periods of time, high-beta shares tend to be the worst performers during market declines.

Problems of CAPM

The model assumes that the variance of returns is an adequate measurement of risk. This would be implied by the assumption that returns are normally distributed, or indeed are distributed in any two-parameter way, but for general return distributions other risk measures (like coherent risk measures) will reflect the active and potential shareholders' preferences more adequately. Indeed risk in financial investments is not variance in itself, rather it is the probability of losing: it is asymmetric in nature. The model assumes that all active and potential shareholders have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption).[citation needed] The model assumes that the probability beliefs of active and potential shareholders match the true distribution of returns. A different possibility is that active and potential shareholders' expectations are biased, causing market prices to be informationally inefficient. This possibility is studied in the field of behavioral finance, which uses psychological assumptions to provide alternatives to the CAPM such as the overconfidencebased asset pricing model of Kent Daniel, David Hirshleifer, and Avanidhar Subrahmanyam (2001).[5]

The model does not appear to adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict. Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves theefficient-market hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but makes the EMH wrong indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market).[citation needed] The model assumes that given a certain expected return, active and potential shareholders will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones. It does not allow for active and potential shareholders who will accept lower returns for higher risk. Casino gamblers pay to take on more risk, and it is possible that some stock traders will pay for risk as well.[citation needed] The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed with more complicated versions of the model.[citation needed] The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitalization. This assumes no preference between markets and assets for individual active and potential shareholders, and that active and potential shareholders choose assets solely as a function of their risk-return profile. It also assumes that all assets are infinitely divisible as to the amount which may be held or transacted.[citation needed] The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capital...) In practice, such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM, and it has been said that due to the inobservability of the true market portfolio, the CAPM might not be empirically testable. This was presented in greater depth in a paper by Richard Roll in 1977, and is generally referred to as Roll's critique.[6] The model assumes economic agents optimise over a short-term horizon, and in fact investors with longer-term outlooks would optimally choose long-term inflation-linked bonds instead of short-term rates as this would be more risk-free asset to such an agent.[7][8] The model assumes just two dates, so that there is no opportunity to consume and rebalance portfolios repeatedly over time. The basic insights of the model are extended and generalized in the intertemporal CAPM (ICAPM) of Robert Merton, [9] and theconsumption CAPM (CCAPM) of Douglas Breeden and Mark Rubinstein.[10] CAPM assumes that all active and potential shareholders will consider all of their assets and optimize one portfolio. This is in sharp contradiction with portfolios that are held by individual shareholders: humans tend to have fragmented portfolios or, rather, multiple portfolios: for each goal one portfolio see behavioral portfolio theory[11] and Maslowian Portfolio Theory.[12]

Empirical tests show market anomalies like the size and value effect that cannot be explained by the CAPM.[13] For details see theFamaFrench three-factor model.[14]

The market is perfectly efficient. That is, every investor receives and understands the same information, processes it accurately, and trades without cost. There is no consideration of the effects of taxation

Definition of 'Security Market Line - SML'

A line that graphs the systematic, or market, risk versus return of the whole market at a certain time and shows all risky marketable securities. Also refered to as the "characteristic line".

Investopedia explains 'Security Market Line - SML'

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.

Security market line (SML) is the representation of the Capital asset pricing model. It displays the expected rate of return of an individual security as a function of systematic, non-diversifiable risk (its beta).[1]