Implications and Limitations of the Capital Asset Pricing Model
Capital Asset Pricing Model
Capital Asset Pricing Model (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
Capital asset pricing model (CAPM) will allow you to determine the required rate of return for any risky asset
Implications of the CAPM:
CAPM indicates what should be the expected or required rates of return on risky assets
This helps to value an asset by providing an appropriate discount rate to use in dividend valuation models
You can compare an estimated rate of return to the required rate of return implied by CAPM - over/under valued ?
Assumptions of the CAPM
1. All investors are Markowitz efficient investors who want to target points on the efficient frontier.
2. Investors can borrow or lend any amount of money at the risk-free rate of return
3. All investors have homogeneous expectations;
4. All investors have the same one-period time horizon such as one-month, six months, or one year
5. All investments are infinitely divisible, which means that it is possible to buy or sell fractional shares of any asset or portfolio
6. There are no taxes or transaction costs involved in buying or selling assets
7. There is no inflation or any change in interest rates, or inflation is fully anticipated.
8. Capital markets are in equilibrium
Efficient Frontier and the Optimal Risky Portfolio
The efficient frontier is a series of portfolios representing the highest return for a given level of risk or the lowest risk for a given expected return
Any individual security will lie inside the efficient frontier, but may be a part of portfolios on the efficient frontier
Choosing the optimal portfolio depends on individual preferences for risk and utility curves
Developing the Capital Market Line (CML)
When a risk free asset is combined with a risky portfolio:
The expected return of this
Capital Asset Pricing Model (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
Capital asset pricing model (CAPM) will allow you to determine the required rate of return for any risky asset
Implications of the CAPM:
CAPM indicates what should be the expected or required rates of return on risky assets
This helps to value an asset by providing an appropriate discount rate to use in dividend valuation models
You can compare an estimated rate of return to the required rate of return implied by CAPM - over/under valued ?
Assumptions of the CAPM
1. All investors are Markowitz efficient investors who want to target points on the efficient frontier.
2. Investors can borrow or lend any amount of money at the risk-free rate of return
3. All investors have homogeneous expectations;
4. All investors have the same one-period time horizon such as one-month, six months, or one year
5. All investments are infinitely divisible, which means that it is possible to buy or sell fractional shares of any asset or portfolio
6. There are no taxes or transaction costs involved in buying or selling assets
7. There is no inflation or any change in interest rates, or inflation is fully anticipated.
8. Capital markets are in equilibrium
Efficient Frontier and the Optimal Risky Portfolio
The efficient frontier is a series of portfolios representing the highest return for a given level of risk or the lowest risk for a given expected return
Any individual security will lie inside the efficient frontier, but may be a part of portfolios on the efficient frontier
Choosing the optimal portfolio depends on individual preferences for risk and utility curves
Developing the Capital Market Line (CML)
When a risk free asset is combined with a risky portfolio:
The expected return of this