The capital asset pricing model (CAPM) is a set of predictions concerning equilibrium expected re¬turns on risky assets. Harry Markowitz laid down the foundation of modern portfolio man¬agement in 1952. The CAPM was developed 12 years later in articles by William Sharpe (1964), John Lintner (1965), and Jan Mossin (1966). The time for this gestation indicates that the leap from Markowitz's portfolio selection model to the CAPM is not trivial.

We summarize the simplifying assumptions that lead to the basic version of the CAPM in the following list. The trust of these assumptions is that we try to assure that individuals are as alike as possible, with the notable exceptions of initial wealth and risk aversion. We will see that conformity of investor behaviour vastly simplifies our analysis. 1.There are many investors, each with an endowment (wealth) that is small compared to the total endowment of all investors. Investors are price-takers, in that they act as though security prices are unaffected by their own trades. This is the usual perfect competition assumption of microeconomics. 2.All investors plan for one identical holding period. This behavior is myopic (short¬-sighted) in that it ignores everything that might happen after the end of the single-period horizon. Myopic behavior is, in general, suboptimal. 3.Investments are limited to a universe of publicly traded financial assets, such as stocks and bonds, and to risk-free borrowing or lending arrangements. It is assumed also that investors may borrow or lend any amount at a fixed, risk-free rate. 4.Investors pay no taxes on returns and no transaction costs (commissions and service charges) on trades in securities. (In reality, of course, we know that investors are in different tax brackets and that this may govern the type of assets in which they invest. In such a simple world,...

...CapitalAssetPricing Model
The CapitalAssetPricing Model otherwise know as CAPM defines the relationship between risk and return for individual securities. William Sharpe published the capitalassetpricing model in 1964. CAPM extended Harry Markowitz's portfolio theory to introduce the notions of systematic and specific risk. For his work on CAPM, Sharpe shared the 1990 Nobel Prize in Economics with Harry Markowitz and Merton Miller
CAPM assumes the concept of a logical investor, assumes a perfect market, and uses a measure of investment risk known as a Beta. When CAPM assumes these three concepts above there has to be a definition to describe the assumptions.
Therefore when we assume a logical investor we are actually referring to an investor that makes his or her investments based upon the expectation of a return. Investors will anticipate their return by analyzing the stock market's average rate of return and that will be their expectation when looking into a specific security. If they are not going to anticipate their return to equal the markets average rate of return then there will be no reason to invest. You invest to make a profit. Investors invest to make a profit. Furthermore a logical investor accepts the market rate of risk. Since they are anticipating the average market rate of return they also have to be...

...CapitalAssetPricing 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...

...
How far the CapitalAssetPricing 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 CapitalAssetPricing Model…………………………………………………..... 3 1. Definition………………………………………………………………………………...3 2. Terminology……………………………………………………………………………...3
Risk and CapitalAssetPricing Model………………………………………………….. 3 1. Systematic Risk…………………………………………………………………………..3 2. Unsystematic Risk………………………………………………………………………..3
Asset Returns and CapitalAssetPricing Model……………………………………….. 3
CapitalAssetPricing Model Explanation…………………………………………….... 4 1. Formula…………………………………………………………………………………..4...

...CAPITALASSETPRICING 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...

...Compare and contrast CAPM and APT?
Capitalassetpricing model (CAPM) and arbitrage pricingtheory (APT) are both methods of assessing an investment's risk in relation to its potential reward and whether the potential investment yield is worthwhile.
CAPM developed by Sharpe 1964. The basic theory behind this model is that investor needs to be compensated for Time Value of Money and the risk that they are taking.
The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk. This is calculated by taking a risk measure of the market (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).
APT developed by Ross 1978. The basic theory of arbitrage pricingtheory is the idea that the price of a security is driven by a number of factors such as macro factors, and company specific factors.
Formula:
r = rf + β1f1 + β2f2 + β3f3 + ⋅⋅
Where r is the expected return on the security,
rf is the risk free rate,
Each f is a separate factor and
each β is a measure of the relationship between the security price and that factor.
The CAPM bases the price of stock on the time value of money (risk-free rate of...

...A Chartered Financial Analyst, Jeffrey Bruner, uses the CapitalAssetPricing Model (CAPM) to help identify mispriced securities. However, a consultant suggests Bruner to use Arbitrage PricingTheory (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 role of CapitalAssetPricing Model (CAPM) is a model that attempts to describe the relationship between the risk and the expected return on an investment and that is used in the pricing of risky securities. The assumption behind the CAPM is that there is only one risk-free rate in the model, investors can borrow and lend unlimited amounts under the risk rate of interest; the perfect information is freely available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and desire to maximise their own utility; and the capital market is characterised by perfect competition, there are broadly diversified across a range of investments and the investors will only require a return for the systematic risk of their portfolio, since unsystematic risk has been removed and can ignored. It also assumes all investors choose their portfolio...

...CAPITALASSETPRICING MODEL (CAPM) The capitalassetpricing model (CAPM) is an important model in finance theory. CAPM is a theory or model use to calculate the risk and expected return rate of an investment portfolio (normally refer to stocks or shares). All stocks have 2 risks: Systematic Risk (also called Market Risk which affect every stocks) and Unsystematic Risk (also called Specific or Unique Risk that only affects individual stocks). To diversify unsystematic risk, we selected and combined different stocks, which are negatively correlated with one another into one portfolio. In this way risk are eliminated greatly. See diagram below.
CAPM Equation The general formula used for CapitalAssetPricing Model is: re = rf + [ ß (rm - rf) ] where the components are as follows: re = Expected return rate of the investment portfolio rf = Risk free rate of return ß = Beta (correlation between the shares and the market) rm = Expected market return which also means: rm - rf = Market risk (systematic risk) ß (rm - rf) = Risk premium *Beta is overall risk value for investing in the stock market. The higher the beta, the more the risk.
CAPM Example Assume there is two Investment portfolio (stocks) or project - A & B. With the information given below, we can use CAPM to help us decide which to invest on. risk free rate beta...

...be used in nearly all situations.
Cost of debt
The dividend growth model analysis began with an observed price and last year’s dividend, so the only item difficult to estimate is the dividend growth rate. If dividends have grown steadily in the past and there is reason to believe that pattern will continue, the historical growth rate can be used as g. Unfortunately, historical dividend growth is seldom that steady (Seitz, Ellison 551).
A problem with the earnings yield model is that it is based on accounting income rather than cash flow. Furthermore, it is based on earnings per share for a past period while the stock price reflects investors’ expectations of future performance (Seitz, Ellison 552).
The mean-variance capitalassetpricing model approach differs from the cost of equity approaches previously discussed in that it focuses on market returns for investments of similar risk rather than investor response to a particular security. Thus, it can be used when earnings and dividends are unstable and when the stock is not publicly traded so there is no market price (Seitz, Ellison 552).
The analysis also found that Joanna’s decision to use the geometric mean of market risk premium, 5.9%, rather than the arithmetic mean was correct as well due to the geometric mean’s inclusion of growth, which is a real world occurrence, making geometric mean a better representation of actual performance.
In finance, the...

1321 Words |
4 Pages

Share this Document

{"hostname":"studymode.com","essaysImgCdnUrl":"\/\/images-study.netdna-ssl.com\/pi\/","useDefaultThumbs":true,"defaultThumbImgs":["\/\/stm-study.netdna-ssl.com\/stm\/images\/placeholders\/default_paper_1.png","\/\/stm-study.netdna-ssl.com\/stm\/images\/placeholders\/default_paper_2.png","\/\/stm-study.netdna-ssl.com\/stm\/images\/placeholders\/default_paper_3.png","\/\/stm-study.netdna-ssl.com\/stm\/images\/placeholders\/default_paper_4.png","\/\/stm-study.netdna-ssl.com\/stm\/images\/placeholders\/default_paper_5.png"],"thumb_default_size":"160x220","thumb_ac_size":"80x110","isPayOrJoin":false,"essayUpload":false,"site_id":1,"autoComplete":false,"isPremiumCountry":false,"userCountryCode":"US","logPixelPath":"\/\/www.smhpix.com\/pixel.gif","tracking_url":"\/\/www.smhpix.com\/pixel.gif","cookies":{"unlimitedBanner":"off"},"essay":{"essayId":36753817,"categoryName":"Fiction","categoryParentId":"17","currentPage":1,"format":"text","pageMeta":{"text":{"startPage":1,"endPage":3,"pageRange":"1-3","totalPages":3}},"access":"premium","title":"The Capital Asset Pricing Theory","additionalIds":[3,7,93,52],"additional":["Business \u0026 Economy","Education","Education\/Greek System","Business \u0026 Economy\/Organizations"],"loadedPages":{"html":[],"text":[1,2,3]}},"user":null,"canonicalUrl":"http:\/\/www.studymode.com\/essays\/The-Capital-Asset-Pricing-Theory-1326518.html","pagesPerLoad":50,"userType":"member_guest","ct":10,"ndocs":"1,500,000","pdocs":"6,000","cc":"10_PERCENT_1MO_AND_6MO","signUpUrl":"https:\/\/www.studymode.com\/signup\/","joinUrl":"https:\/\/www.studymode.com\/join","payPlanUrl":"\/checkout\/pay","upgradeUrl":"\/checkout\/upgrade","freeTrialUrl":"https:\/\/www.studymode.com\/signup\/?redirectUrl=https%3A%2F%2Fwww.studymode.com%2Fcheckout%2Fpay%2Ffree-trial\u0026bypassPaymentPage=1","showModal":"get-access","showModalUrl":"https:\/\/www.studymode.com\/signup\/?redirectUrl=https%3A%2F%2Fwww.studymode.com%2Fjoin","joinFreeUrl":"\/essays\/?newuser=1","siteId":1,"facebook":{"clientId":"306058689489023","version":"v2.8","language":"en_US"},"analytics":{"googleId":"UA-32718321-1"}}