5.1 CAPM and Expected Return

Why CAPM appears on the UCP exam

Module 1 — Fundamentals of Investments (about 25% of the TOAP UITF Certification Program Qualifying Exam) expects you to connect risk and return in a way clients can understand. The Capital Asset Pricing Model (CAPM) is the standard classroom model that answers: Given how much market risk a stock or portfolio has, what return should investors expect?

You do not need CFA-level proofs or multi-factor models. You need the formula, the meaning of each term, directional relationships, and the link to equity and multi-asset UITFs that mark holdings to market and reprice NAVPU when the Philippine (or global) equity market moves.

The CAPM formula (memorize exactly)

E(r) = rf + β(rm − rf)

Rewrite it in words:

Expected return = risk-free rate + (beta × market risk premium)

The product β(rm − rf) is often called the asset’s risk premium (how much extra return that asset should offer given its beta).

Risk-free rate in a Philippine conceptual setting

CAPM assumes a risk-free asset: certain nominal return over the period of analysis, no default, and (in pure theory) no reinvestment uncertainty for the horizon used. In practice, exam and industry discussions use a government short-rate proxy:

• Short-term Philippine Treasury bills or analogous peso government paper
• A rate closely tied to the Bangko Sentral ng Pilipinas (BSP) policy-rate environment

For UCP teaching examples you may see something like:

• rf = 5% (illustrative short-term peso government rate)
• rm = 12% (illustrative expected Philippine equity market return)
• Market risk premium (rm − rf) = 7%

These numbers are teaching placeholders, not forecasts you should quote as facts to clients. What matters is the structure: peso risk-free base + premium for equity market risk.

UITF link: Money-market UITFs (short deposits and fixed income under Circular 1152 maturity rules) sit closer to the risk-free / low-volatility end of the spectrum. Equity UITFs (≥80% NAV in equities) sit far closer to rm and can move with market beta. Multi-asset / balanced UITFs sit in between.

Market risk premium

(rm − rf) is the compensation the market offers for systematic risk. If investors can earn 5% risk-free and expect 12% from the broad equity market, they require 7 percentage points of extra expected return for holding diversified equity market risk.

Important exam points:

1. The premium is for market (systematic) risk, not for company-specific noise that diversification can reduce.
2. A higher assumed market premium raises E(r) for every asset with positive beta, all else equal.
3. A higher rf raises the base of every CAPM expected return; if rm is fixed, a higher rf can shrink (rm − rf), so exam questions always state which inputs change.

Beta inside CAPM

From the prior chapter on portfolio risk measures, beta measures how much an asset’s returns tend to move with the market:

CAPM’s core economic claim for the exam: only systematic risk is priced. Diversifiable unsystematic risk should not increase required return in a well-diversified portfolio, because investors can eliminate it. Equity UITFs already diversify across many issues, so their day-to-day NAVPU risk is dominated by market / sector systematic factors—exactly the world CAPM describes.

Worked CAPM examples (PHP / percent terms)

Use rf = 5%, rm = 12%, so (rm − rf) = 7%.

Example 1 — Market-like equity exposure (β = 1.0)

E(r) = 5% + 1.0 × 7% = 12%

A diversified Philippine equity UITF that behaves like the broad market should, under CAPM, offer about the market’s expected return—not the money-market rate.

Example 2 — Aggressive stock / growth sleeve (β = 1.4)

E(r) = 5% + 1.4 × 7% = 5% + 9.8% = 14.8%

Higher systematic risk → higher required return. Clients who want growth must accept larger NAVPU swings when PSEi or sector indices drop.

Example 3 — Defensive equity (β = 0.6)

E(r) = 5% + 0.6 × 7% = 5% + 4.2% = 9.2%

Still above rf, but below full market expected return. Lower beta does not mean “no risk”—only less market sensitivity.

Example 4 — Balanced / multi-asset fund (illustrative β = 0.5)

A multi-asset UITF mixing peso bonds and equities might show a portfolio beta well below 1.0 relative to the equity market:

E(r) = 5% + 0.5 × 7% = 8.5%

This is stylized: actual balanced-fund risk also includes interest-rate risk on the bond sleeve. CAPM here is a market-risk lens, not a complete multi-factor description of every UITF risk.

Snapshot table

Security market line (SML) intuition

Graphically, CAPM is the security market line: expected return on the vertical axis, beta on the horizontal axis. The line starts at rf when β = 0 and slopes upward by the market risk premium. Assets plot on the SML if fairly priced under CAPM.

• Above the SML (expected/forecast return higher than CAPM requires for that beta): relatively attractive / underpriced in CAPM language.
• Below the SML: relatively unattractive / overpriced.

UCP depth is light: know that higher beta → higher required return along the SML, and that the intercept is the risk-free rate.

What CAPM is not

Linking CAPM to UITF product risk discussions

When a client compares a money-market UITF, a peso bond fund, a balanced fund, and an equity fund:

1. Expected return ranking (long-run, not a promise): equity > balanced > longer bond > money market (typical, risk-adjusted and cycle-dependent).
2. CAPM story for equities: higher β versus the equity market justifies higher E(r).
3. Client cost of that E(r): larger drawdowns when markets fall; daily mark-to-market hits NAVPU.
4. Suitability: Client Suitability Assessment (CSA) and Risk Disclosure Statement (RDS) must match willingness and ability to bear market risk—not just “chase CAPM expected return.”

Marketing personnel who quote a high historical equity return without mentioning beta-driven volatility violate the spirit of fair dealing even if they never write the CAPM equation on a whiteboard.

Exam traps for this section

1. Wrong formula order — it is rf plus beta times premium, not beta times (rf + rm).
2. Using total SD instead of beta — CAPM prices β, not raw standard deviation alone.
3. Treating (rm − rf) as optional — the premium is the heart of the risk compensation term.
4. Promising E(r) as guaranteed UITF yield — expected return ≠ contractual return.
5. Saying unsystematic risk raises CAPM required return — in the model, diversified unsystematic risk is not priced.

Quick formula checklist

1. Write E(r) = rf + β(rm − rf).
2. Compute premium = rm − rf.
3. Multiply by β.
4. Add rf.
5. Interpret: higher β → higher E(r); result is required/expected, not guaranteed NAVPU growth.