On its surface, the CAPM sounds pretty dry; standing for the Capital Asset Pricing Model, the tool originally designed by William Sharpe has remained an important part of asset valuation–and not just valuation, but of the future of world economies and the political debate on who deserves what and how we should structure our societies in the future.
Sound like an outlandish claim? Let’s zero in on the Rf part of the formula (in its full, E(Ri) = Rf + Beta(i)(E(Rm)-Rf), the Rf there standing for the risk-free rate of return). This refers to the counterfactual hypothetical return when analyzing an investment. If, say, I want to invest in a company and I believe my profit will be 7% (here the E(Ri), whereas the broader market (E(Rm)) gets me just 6%, I will only take the investment if the gap between the two is sufficiently large enough relative to the risk-free rate of return (Rf).
In other words, if I want to bet on a really risky stock instead of an index fund (SPY, VOO, VTI), I’m only going to do so if the rate of return sufficiently exceeds the market’s rate of return above a risk-free rate.
You might notice two problems already. The first is that the risk-free rate is ill defined; what is a risk-free rate? That will vary in different contexts, but in modern investing in America that is typically defined by the interest rate on U.S. Treasuries. Which brings us to our second problem: if that rate goes to zero, or is negative (as are the yields of some bonds in Europe), our CAPM formula has broken down.
Let’s stick with the 6% market return assumption and use a Treasury yield from long ago–the 1990s–when this formula worked well. We’ll assume a beta of 2 for a relatively risky investment and use a 4% risk-free rate; our CAPM model tells us to expect an 8% total return, and anything higher means the investment in question is a good one.
If we lower our risk-free rate to the current 10-year rate of 1.5%, suddenly our model is telling us to expect a 10.5% return.
Nothing about the investment itself has changed, but the method of assessing the optimal return for a risky investment is now telling us to expect a higher return. Since the CAPM method is widely used to inform investment decisions–and, crucially, because people are aware of the popularity of the CAPM method–the low risk-free rate encourages higher valuations, which encourages more aggressive investing in higher risk assets.
This is the fundamental argument against the financial risk of establishing low interest rates. This, of course, is massively offset by the benefits of low interest rates in times of financial crisis (most crucially: they lower the risk of a great depression or economic crisis), but it does lead to the question of whether, as a tool, CAPM is something that should be widely used at all, both for the greater good and for the benefit of an individual investor.
And this is why, quietly but decisively throughout pockets of the institutional investment world, the CAPM formula is becoming less and less important in the investment decision making process. Some modelers are not using it at all, favoring methods that don’t rely on a risk-free rate at all. Others, perhaps more dangerously, are favoring different valuations on alternative metrics like price-to-sales ratios.
Nonetheless, the spectre of CAPM-based valuations has created an intense stir and political momentum. Some argue the important of valuing assets based on a risk-free rate creates an obligation to increase interest rates very fast and not let them get low–doing so creates financial bubbles, they say, that will hurt the economy more than raising rates too quickly (there is little evidence to support this view, but it has become popular over the last decade).
That pressure may have even influenced the Federal Reserve’s decision to hike rates in the mid-2010s–and whether that was a good or bad idea remains undecided and up for debate. Still, one can see from all of this fervor how a single very simple formula has reshaped not just financial worlds, but an important part of public policy, both in the U.S. and around the world.