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This paper looks at The Capital Asset Pricing Model (CAPM) and how it can be used by fund managers when making investment decisions and the interaction of CAPM when calculating Alpha which enables investors to assess the fund manager’s performance.
I will outline the principles of the two measures including any limitations that they present along with my conclusion.
Part 1 – CAPM
CAPM is considered to be an important device in financial management having been developed by three academics, Sharpe, Lintner and Mossin during 1964 – 1966 (1).
William Sharpe actually published CAPM which was an extension of previous work conducted by
Markowitz’s portfolio theory where he introduced the idea of systematic and unsystematic risk (2).
The*…show more content…*

The CAPM formula is of follows (4). E (ri) = Rf + Bi (E (rm) – Rf) E (ri) = return required on financial asset i Rf = risk-free rate of return Bi = beta value for financial asset i E (rm) = average return on the capital market So, E (ri) is the cost of equity and the premium an investor should expect for taking on the additional risk and CAPM is based on a set of assumptions, including (5) : • All investors are rational and risk adverse • All investors have an identical holding period • No one individual can affect the market price • No taxes or transaction costs are taken into consideration • Unlimited borrowing and lending of risk free money It wasn’t until after the bear market (this is a declining market and it tends to begin with a sharp drop in stock prices across the board) of 1973 – 1974 that CAPM was really accepted and adopted by the world of finance lead by Wall Street (6). During the period of January 1973 to December 1974, the stock market (DJIA) reduced in value by 46%, a steep increase in unemployment and a high rate of inflation around 11% in the US (7). Even the UK suffered with strikes and an eventual change in government. Empirical evidence in the early years of CAPM provided support especially with Sharpe and Copper (1972). (8) During their testing, they used all stocks in New York stock exchange over a period between 1926 – 1968. Their research found past Beta could be used for future

The CAPM formula is of follows (4). E (ri) = Rf + Bi (E (rm) – Rf) E (ri) = return required on financial asset i Rf = risk-free rate of return Bi = beta value for financial asset i E (rm) = average return on the capital market So, E (ri) is the cost of equity and the premium an investor should expect for taking on the additional risk and CAPM is based on a set of assumptions, including (5) : • All investors are rational and risk adverse • All investors have an identical holding period • No one individual can affect the market price • No taxes or transaction costs are taken into consideration • Unlimited borrowing and lending of risk free money It wasn’t until after the bear market (this is a declining market and it tends to begin with a sharp drop in stock prices across the board) of 1973 – 1974 that CAPM was really accepted and adopted by the world of finance lead by Wall Street (6). During the period of January 1973 to December 1974, the stock market (DJIA) reduced in value by 46%, a steep increase in unemployment and a high rate of inflation around 11% in the US (7). Even the UK suffered with strikes and an eventual change in government. Empirical evidence in the early years of CAPM provided support especially with Sharpe and Copper (1972). (8) During their testing, they used all stocks in New York stock exchange over a period between 1926 – 1968. Their research found past Beta could be used for future

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