9.6 Important Implications of the CAPM/SML
Learning Objectives
- Describe how the Security Market Line (SML) predicts that high beta stocks should earn higher returns than low beta stocks and discuss the role of beta as the primary factor influencing differences in stock returns.
- Evaluate how rising interest rates and increased investor risk aversion affect required returns and stock prices, using the concepts of the risk premium and equilibrium conditions.
- Critically analyze the empirical findings and limitations of the Capital Asset Pricing Model (CAPM) and the Security Market Line (SML), and explore alternative models that have been proposed to explain stock returns.
Consider the following:
- According to the SML, high beta stocks should, on average, earn higher returns than low beta stocks.
- According to the SML, the only factor that should cause consistent differences in returns across stocks is beta.
- When interest rates rise, required returns should increase and (all else equal) cause stock prices to decline.
- When investors become more risk-averse, the risk premium [latex](\bar{k_{m}}-k_{RF})[/latex] should increase which will increase required returns and (all else equal) cause stock prices to decline.
Under equilibrium conditions, the required return should equal the expected return. Let’s consider this for a minute. In our example above, we estimated that the required return for stock B should be [latex]13.4\%[/latex]. What would happen if the expected return [latex]\bar{k}[/latex] for this stock was [latex]16\%[/latex]?
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For practice in understanding this concept, think through what would happen if the required return was [latex]13.4\%[/latex] and the expected return was [latex]9\%[/latex]. Also, think about what types of things may push us out of equilibrium and why this is relevant for explaining stock price movements.
Empirical Findings of the SML
While the CAPM/SML met with a lot of early success and became the standard for estimating required returns in the field of finance very quickly, it ran into problems in the 1990s and is deemed less reliable at the moment. (Fama and French, 1992) There have been some alternative models (Fama-French 3-Factor model, Carhart 4-Factor model, Fama-French 5-Factor model, and the q-Factor model) introduced since then. However, there has not been a new standard-bearer to take its place. As of right now, the SML is still commonly used in practice. However, there is a growing focus on the alternatives. My view is that it is critical for you to know and understand the basic premise of the CAPM and SML (that role of market risk in explaining returns) and to be aware of some of the problems (listed below).
- While market returns play a major role in explaining the returns of individual stocks, Beta doesn’t do a very good job of explaining future returns. In other words, after controlling for other factors, it is not clear that high beta stocks actually outperform.
- Small firms seem to earn higher returns than can be explained by beta.
- Firms with a low market-to-book ratio (MV/BV) tend to earn higher returns than can be explained by beta.
- Firms that have been top performers in the past 6-12 months tend to earn higher returns in the following 6-12 months than can be explained by beta.
Again, the above flaws do not mean that the CAPM/SML are useless. They provide a simplified framework for understanding how market risk relates to returns. However, recognize that they are not perfect models and the process of understanding stock returns is more complex than the SML indicates. As our knowledge increases, better models will likely evolve.
Attribution
“Chapter 7 – Risk Analysis” from Business Finance Essentials by Dr. Kevin Bracker; Dr. Fang Lin; and Jennifer Pursley is licensed under a Creative Commons Attribution-NonCommercial 4.0 International License, except where otherwise noted.
