Capital Asset Pricing Model
Introduction
Economic models are always intended to simplify the real-world complex economic issues and provide efficient information to the users, and such role is taken by Capital Asset Pricing Model (CAPM) as well. The CAPM is the key theory in the stock market and industries; it is widely used by analysts, investors and corporations. In this essay I am going to discuss the recent developments about the CAPM, and refer to both advantages and disadvantages.
Capital Asset Pricing Model
The initial development of the CAPM was building upon Markowitz’s idea, and the model was further developed by Sharpe, Treynor, Lintner, Mossion in 1960s. Basically, the Capital asset pricing model shows the theory of the relationship between risks and returns which state that the expected risk premium on any security equals its beta time the market risk premium. (Brealey/Myers/Marcus, 2009) In other word, the CAPM laid the basis for modelling the risk-return relationship, it is considered as the central theory that links risk and return for all assets and it is based on very strong assumptions.
The reasons of why the CAPM became so popular and has been widely used since it has been introduced to the market are not only due to the simple form and easy to understand, but also due to the wide range of applications.
1. Calculates the expect rate of return
The basic idea behind the model is that the investors expect a reward for both waiting and worrying, thus the CAPM has a simple interpretation, which are the expected rates of return required by investors rely on two things:
• Compensation for the time value of money which indicates by the risk-free rates
• A risk premium, which depends on beta and the market risk premium. The investors is rewarded with the risk premium for taking on the risk associated with the investment 2. Contribute to the asset classification and allocate resources
Risk depends on exposure to macroeconomic events and can be measured as the
Economic models are always intended to simplify the real-world complex economic issues and provide efficient information to the users, and such role is taken by Capital Asset Pricing Model (CAPM) as well. The CAPM is the key theory in the stock market and industries; it is widely used by analysts, investors and corporations. In this essay I am going to discuss the recent developments about the CAPM, and refer to both advantages and disadvantages.
Capital Asset Pricing Model
The initial development of the CAPM was building upon Markowitz’s idea, and the model was further developed by Sharpe, Treynor, Lintner, Mossion in 1960s. Basically, the Capital asset pricing model shows the theory of the relationship between risks and returns which state that the expected risk premium on any security equals its beta time the market risk premium. (Brealey/Myers/Marcus, 2009) In other word, the CAPM laid the basis for modelling the risk-return relationship, it is considered as the central theory that links risk and return for all assets and it is based on very strong assumptions.
The reasons of why the CAPM became so popular and has been widely used since it has been introduced to the market are not only due to the simple form and easy to understand, but also due to the wide range of applications.
1. Calculates the expect rate of return
The basic idea behind the model is that the investors expect a reward for both waiting and worrying, thus the CAPM has a simple interpretation, which are the expected rates of return required by investors rely on two things:
• Compensation for the time value of money which indicates by the risk-free rates
• A risk premium, which depends on beta and the market risk premium. The investors is rewarded with the risk premium for taking on the risk associated with the investment 2. Contribute to the asset classification and allocate resources
Risk depends on exposure to macroeconomic events and can be measured as the