Capital Asset Pricing Model

Topics: Capital asset pricing model, Modern portfolio theory, Investment Pages: 8 (2370 words) Published: December 15, 2013

How far the Capital Asset Pricing Model has been successful in explaining asset returns, defining its approach and assumptions.

Semester 2013
Department of Accounting and Finance
Lord Ashcroft International Business School
Anglia Ruskin University
Table of Contents
Introduction…………………………………………………………………………......... 3 What’s Capital Asset Pricing Model…………………………………………………..... 3 1. Definition………………………………………………………………………………...3 2. Terminology……………………………………………………………………………...3 Risk and Capital Asset Pricing Model………………………………………………….. 3 1. Systematic Risk…………………………………………………………………………..3 2. Unsystematic Risk………………………………………………………………………..3 Asset Returns and Capital Asset Pricing Model……………………………………….. 3 Capital Asset Pricing Model Explanation…………………………………………….... 4 1. Formula…………………………………………………………………………………..4 2. Beta……………………………………………………………………………………....4 3. Security Market Line (SML) and graphical representation……………………………...4 Critique of Capital Asset Pricing Model Assumptions………………………………... 5 Shortcomings of Capital Asset Pricing Model…………………………………………. 6 1. Advantages of CAPM…………………………………………………………………...6 2. Limitations………………………………………………………………………………6 3. Arbitrage Pricing Theory (APT) vs. Capital Asset Pricing Model (CAPM)……………6 Conclusion……………………………………………………………………………….. 7 References……………………………………………………………………………….. 8

Introduction
Based on the remarkable historical contribution to financial mathematics by Markowitz (1959) on Diversification and Modern Portfolio Theory, in which he developed a framework assuming that investors are risk-averse and only choose mean-variance-efficient portfolios; Treynor (1961, 1962), Sharpe (1964), Lintner (1965) and Mossin (1966) independently introduced Capital Asset Pricing Model. Sharpe and Lintner add two assumptions of complete agreement (where all investors have the same opinion on the combined allotment of asset returns) and borrowing and lending at a risk free rate (which is the same rate for all investors regardless of any amount borrowed or lent) in Markowitz Model (resulting in a Nobel Prize in Economics for Sharpe and Markowitz) (Eugene F. Fama and Kenneth F. French, 2004). What’s Capital Asset Pricing Model (CAPM)?

CAPM introduced the proposal of risk measurement in stable market in order to price financial assets and securities. According to Investpedia.com, CAPM is a model that describes the relationship between risk and expected return on an asset and that is used in pricing of risky securities. This model accounts for asset’s sensitivity to Systematic/Market Risk (general economy risk/risk associated with the financial system) only rather than the Total Risk (Systematic and Unsystematic risk, where Unsystematic Risk is company’s particular risk) adding the market return and risk-free asset expected return. Every investor will bear the same risk as they hold diversified portfolios and only Systematic Risk is priced by rational investors because it...
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