This article throws light upon the top four asset pricing implications of CAPM.
1. The CAPM has asset pricing implications because it tells what required rate of return should be used to find the present value of an asset with any particular level of systematic risk (beta). In equilibrium, every asset’s expected return and systematic risk coefficient should plot as one point on the CAPM.
If the assets expected rate of return is different from its required rate of return, that asset is either underpriced or overpriced.
This implication is useful only if the beta coefficients are stable over time. However, in reality, the betas of assets do change with the passage of time as the assets’ earning power changes. The job of security analyst is, thus, to find the assets with dis-equilibrium prices, because it will be profitable to buy underpriced assets and sell short the overpriced assets.
2. With the help of CAPM, every investor can analyse the securities and determine the composition of his portfolio. Since, there is a complete agreement among investors on the estimates of expected return, variances and covariances and risk free rate, efficient set of portfolio should be the same for all the investors.
Since all the investors face the same efficient set, the only reason they choose different portfolios is that they have different indifference curves. An indifference curve is the locus of all possible portfolios that provide the investor with the same level of expected utility. Expected utility will increase as one move from lower indifference curve to a higher indifference curve.
But on the same indifference curve, any point on the curve gives the same utility. Such curves are positively sloped and convex for risk averters, concave for risk seekers and horizontal for risk neutral investors. Thus, different investors will choose different portfolios from the same efficient set because they have different preference towards risk and return.
It implies that each investor will spread his funds among risky securities in the same relative proportion adding risk free borrowing or lending in order to achieve a personally preference overall combination of risk and return. This feature of CAPM is often referred to as separation theorem.
3. Another important implication is that no security can in equilibrium have a tangency to touch, either axis on risk return space. If an investor has zero proportion in such securities, the prices of these would eventually fall, thereby causing the expected returns of these securities to rise until the resulting tangency portfolio has a non-zero proportion associated with it. Ultimately everything will be balanced out.
When all the price adjustments stop, the market will be brought into equilibrium, subject to the following conditions:
(a) Each investor will like to hold a certain positive amount of each risky security.
(b) The current market price of each security will be fixed at a level where the number of shares demanded equals the number of shares outstanding.
(c) The risk free rate will be fixed at a level where the total amount of borrowings will be equal to the total amount of money lent.
As a result, in equilibrium the proportion of the tangency portfolio will correspond to the proportion of the market portfolio. The market portfolio is a portfolio consisting of all the securities where the proportion invested in each security corresponds to its relative market value.
The market portfolio plays a very important role in the CAPM because efficient set consists of an investment in the market portfolio coupled with a desired amount of either risk free borrowing or lending. Tangency portfolio is commonly referred to as the market portfolio.
4. For any individual investor, security prices and returns are fixed, whereas the quantities held can be altered. For the market as a whole, however, these quantities are fixed (at least in the short run) and prices are variable.
As in any competitive market, equilibrium requires the adjustment of each security’s price till there is consistency between the quantity desired and quantity available. Therefore, is but reasonable and logical that historical returns on securities should be examined to determine whether or not securities have been priced in equilibrium as suggested by the CAPM.