3.15 Changes in the CAPM
Let’s make some simple points here:
- The CAPM provides us with the “Required Return” (R), which we import into the DDM.
- The Security Market Line (SML) is not static, it is “dynamic and will change continually. The “SML” is what we call the line within the CAPM.
This brings up a simple question: What may cause the CAPM to change?
The answers are also pretty simple:
- A change in inflation, or in inflation expectations, will cause RF to shift (up or down); the Fed may tighten or loosen in response. When the Fed engages in Open Market Operations, it impacts short-term rates the most, RF will thus be affected. The SML will shift up or down – in parallel fashion, ceteris paribus.
- Risk premia will increase when times are bad (recession) and decrease when times are good (prosperity). In bad times, investors are more nervous about the future and the economy; they feel less secure. Thus, for the same degree of risk as before, investors will – later – demand a higher risk premium – above the risk-free rate, to compensate them for the added nervousness.
Increases in the market risk premium cause a shift upward in the slope of the SML. Diagrammatically, this means that RM – RF will increase when times are bad and vice versa. (A similar phenomenon occurs with bonds – credit spreads[1], i.e., the difference in market yields between investment grade and high yield bonds, increase in bad times; the increase is illustrative of general market nervousness.)
- Both inflation and risk premia may move.
- While the CAPM may not change, a company’s creditability (i.e., default risk) may change leading to a change in its Beta and, hence, in its discount rate (R). This may result from a re-rating of its bonds, or from a change in its capital structure, which, in turn, affects the company’s ability to pay dividends and retain earnings. In this case, there is no change in the SML, but the firm’s Beta will move to the right or left along the x-axis.
Exercise:
Diagram the axes and the relevant points along each of the axes, and graph the movements described in the three or four (depending on how you count them) bullets above. The diagrams are provided on the next page. Don’t look!
- For a discussion of Credit Spreads, see Introduction to Financial Analysis by Dr. K. Bigel, Section #13.9 <https://pressbooks.pub/introductiontofinancialanalysis/> ↵
