Capital Asset Pricing Model

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CAPITAL ASSET PRICING MODEL

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk [pic]premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

THE CAPM MODEL

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

[pic]
The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the [pic]formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

What are the difference and similarities between CAPM and APT?

Financial experts, shareholders and also for the investors must always be aware of the returns to expect from the stocks in which they invest. Many statistical models are available that are comparable to different values ​​on that are based on the yearly yield, so as to facilitate the investors to decide upon the values ​​in a more prudent manner. CAPM and APT are two such assessment tools. Before we try to discover the differences between CAPM and APT, let us take a closer look at both theories. 

A result of its ability to fairly assess the pricing of the different stocks in the market, Arbitrage Pricing Theory or APT has gained a lot of popularity among the investors. The fundamental assumption of APT is that the value of a stock is determined by a number of factors that include several macro factors as well as those that are specific to a company. First there are macro factors that are applicable to all companies and then there are the company specific factors. The following equation is employed to find the expected rate of return of a stock. r= rf+ b1f1 + b2f2 + b3f3 + ….. 

Here r is the expected return on security, f is a number of factors affecting the price of security and b is the measure of relationship between security price and factor.

 In an interesting way, the same formula is used to calculate the rate of return in case of CAPM too, which is also known as the Capital Asset Pricing Model. But, the difference is in the way a single non-company factor and a single measure correlation are used among price of asset and the factor in case of CAPM while there are numerous aspects and diverse measures of relationships between asset price and various factors in APT. 

In APT, the performance of capital is to be considered independent of the market and its price is assumed to be driven by the company and non company specific factors. But, a disadvantage of APT is that no test can discover these factors and in fact one has to find empirically if factors of each company in which he is interested in finding the binding price. More number of factors identified, the more complicated becomes the task of finding different measures of relationships with different factors as well. These are the reasons why CAPM is preferred by investors as well as financial experts.

ASSUMPTIONS OF CAPM

The assumptions of the Capital Asset Pricing Model explaining its limitations when using for a hedge fund assessment. Based on the Markowitz’s mean-variance model, the CAPM...
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