Capital Asset Pricing Model (CAPM): Pros and Cons.

CAPM defines the relationship between risk and return. The premise of the model is that the expected investment return varies in direct proportion to its risk, i.e., the riskier the investment - the higher the return you should expect. Shows:

•how much risk you are taking when investing in an instrument? •whether the instrument is rightly priced
•whether you are getting sufficient return for the risk you are taking

CAPM calculates the risk-adjusted discount rate with the risk-free rate, the market risk premium, and beta (mathematical formula):

Return (R) = Rf + beta x (Rm - Rf)

Rf is the rate of risk-free investments
Beta - the risk of loss associated with your investments.
Rm is the expected market return.
(Rm-Rf) – market risk premium
beta x (Rm - Rf) – risk premium of specific company

Investments are good if the expected return from the investment equals/exceeds required return.

Market Risk Premium [Rm-Rf]
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk Its size depends on the perceived risk of the overall stock market and investors’ degree of risk aversion Varies across time. Usually ranged between 4-8%

BETA in CAPM measures a stock’s degree of systematic or market risk. It can also be thought of as the stock’s contribution to the risk of a well-diversified portfolio •beta = 1 the stock has average market risk. The stock generally tends to go up (down) by the same percentage amount as the market •beta = 1.5 the stock generally tends to go up (down) by 50% (1.5x) more than the market •beta = 0.5 the stock generally tends to go up (down) by half as much as the market •beta = 0 the stock has no correlation with movements in the overall stock market. All of the firm's risk would actually be firm-specific risk •beta < 0 the stock generlly tends to move in a direction opposite that of market (very rare)...

...ADVANTAGES, AND DISADVANTAGES
THE CAPITALASSETPRICINGMODEL RELEVANT TO ACCA QUALIFICATION PAPER F9
Section F of the Study Guide for Paper F9 contains several references to the capitalassetpricingmodel (CAPM). This article is the last in a series of three, and looks at the theory, advantages, and disadvantages of the CAPM. The first article, published in the January 2008...

...CapitalAssetPricingModelCapitalAssetPricingModel (CAPM)
Capital market theory extends portfolio theory and develops a model for pricing all risky assets. It is an equation that quantifies security risk and defines a risk/return relationship
Capitalassetpricing...

...Case Study of Cost of Capital at Ameritrade
1-a How can the CAPM be used to estimate the cost of capital for a real business investment decision?
CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy....

...CAPITALASSETPRICINGMODEL
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...

...Introduction
Capitalassetpricing has always been an active area in the finance literature. CapitalAssetPricingModel (CAPM) is one of the economic models used to determine the market price for risk and the appropriate measure of risk for a single asset. The CAPM shows that the equilibrium rates of return on all risky assets are function of their...

...RISK & CAPITALASSETPRICINGMODEL | |
|Every financial investment contains some | |To see how the risk matrix (see below) described in this tutorial is used, please |
|level of financial risk. This risk is | |take a look at FinanceIsland's ROI analysis tool. You can try it out
|usually expressed through the discount rate | |by subscribing for a free trial. ...

...calculation for debt. Nike’s total interest expense was $58.7 million, so their cost of debt was found to be 4.3%. Joanna used a tax rate of 38% in her calculations, making Nike’s cost of debt after tax to be 2.7%. Joanna decided to use the CAPM model in her calculation of Nike’s cost of equity. She used the risk-free rate of 5.74% on a 20-year Treasury bond, the geometric mean for market risk premium from 1929 to 1999 which was 5.9%, and Nike’s average beta from 1996 to...

...Jeffrey Bruner, uses the CapitalAssetPricingModel (CAPM) to help identify mispriced securities. However, a consultant suggests Bruner to use Arbitrage Pricing Theory (APT) instead. As the following, it will mention the role of CAPM in the modern portfolio management; to clarify the APT faction and explain the reasons why should Bruner use APT to help identify mispriced securities.
In modern portfolio management, the...