Capital Asset Pricing Model (Capm)

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. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.

This essay will highlight the use of Capital asset pricing model ( CAPM ) to be considered as a pricing theory model for assets . CAPM model helps investors to analyse the risk and what expectation to keep from an investment (Banz , 1981) . There are two types of risk

The capital asset pricing model can be used to determine the rate of return for an asset that is risky. This model aims at assuring that investors are compensated for the risk and the value of money. Therefore, the expected return on a security is equal to the rate of a risk-free security and the risk premium. Risk premium is the minimum amount of money expected in return of an asset that is risky. The risk premium must exceed risk-free and less risky assets.

“r” is the portfolio's rate of return, Rf is the risk-free return rate, and Km is the return of the whole stock market. The "three factor" β is analogous to the classical β but not equal to it, since there are now two additional factors to do some of the work. SMB stands for "small (market capitalization) minus big" and HML for "high (book-to-price ratio) minus low"; they measure the historic excess returns of small caps over big caps and of value stocks over growth stocks.

To reduce a firm’s specific risk or residual risk a portfolio should have negative covariance or rather it should have no variance at all, for large portfolios however calculating variance requires greater and sophisticated computing power. As such, Index models greatly decrease the computations needed to calculate the optimum portfolio. The use of such Index models also eliminates illogical or rather absurd results. The Single Index model (SIM) and the Capital Asset Pricing Model (CAPM) are such models used to calculate the optimum portfolio.

To determine required returns, the total risk exposed to the investor’s portfolio must be evaluated. By looking at the investor’s portfolio, we can determine the specific risk unique to that portfolio. We also need to take into account of the market risk that all portfolios are exposed to. These two risks make up the total risk (Mad Fientist 2012).

One assumption of CPAM model is that all investors invest in the same portfolio with the highest expected excess return per unit of risk and combine leverage using risky-free assets to maximize their utility. However, there are some investors constrained in such kind of leverage due to margin requirements or any prohibitions. For these investors, they tend to overprice the risky high-beta assets instead of leverage. Therefore, the risky assets with higher betas require lower risk-adjusted returns than lower-beta assets with leverage because the tilting behavior alleviates the no-leverage constraint (Black, Jensen and Scholes 1972). Here the BAB strategy generates a funding constrained CAPM model which is based on the standard CAPM model but provides a more practical implement to investors’ portfolio construction.

This report aims at implement two distinct approaches, which can indicate the expected return and risk of a two-stock portfolio, to generate a practical solution to risk-analyzing for stock-investing. The two approaches are Mean-Variance Approach and CAPM Approach. While we apply the Mean-Variance Approach to determine the expected return and standard deviation, we employ the CAPM approach to measure the beta and expected return of each stock. The calculations of the aforesaid mathematical characteristics will contain the weekly returns during a seven-year time period integrated with the ASX all ordinaries Accumulation Index as a substitute for the market index and Official Cash Rate (thereafter, OCR, which is the interest

The key goal for any financial manager is to manage risk, by finding the appropriate balance between the levels of risk so that both risk premium and return can be maximised with as little risk as possible. By understanding risk and return any financial manager can implement formulas such as the one shown above to better understand the investments potential and harness the best outcome for the individual or firm.

The analysis of this paper will derive the validity of the Fama and French (FF) model and the efficiency of the Capital Asset Pricing Model (CAPM). The comparison of the Fama and French Model and CAPM (Sharpe, 1964 & Lintner, 1965) uses real time data of stock market to practise its efficacy. The implication of the function in realistic conditions would justify the utility of the CAPM theory. The theory suggests that the expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the expected return on the market portfolio, the variance of the return on the market portfolio, and

The expected return for each of the stocks has been calculated by the Capital Asset Pricing Model. The risk free rate is one of the variables used in the CAPM formula. The risk free rate has been assumed here at 7% based on historical statistics as no information has been given regarding it. The second variable is the return on market. This return has been estimated from the average monthly return by transforming it into effective expected annual rate of return. Finally, the third variable used in the CAPM formula is beta which has been calculated in the third question. This beta incorporates the systematic risk in the formula to calculate the expected return for a particular stock. The expected return for Brown Group is 14.87% and for California RIET it is 8.00%. This shows that the expected return for Brown Group is much higher than the expected return of California RIET.

A well diversified investor is at an advantage when participating in the investing of securities because the more diversified he or she is, the less unsystematic risk he or she will have to deal with. The reduction of risk is a fundamental principle in risk management. There are different methods of analyzing the risk of an equity security; some highlighted in the previous questions (6-10) show that the mean return of a company called Zemin Corporation is at 24% annually. The standard deviation of this expected return is 3.46. Also, we know that its beta is 1.54. Both its standard deviation and beta are relatively small for such a high return. With this much data available, a large amount of risk management techniques and formulas can be utilized to determine if this investment is worth partaking in. The capital asset pricing model for example, shows an investor an appropriate return for the amount of systematic risk that would be undertaken by the investor for purchasing the security. This systematic risk is the beta. The Sharpe ratio is another method of analyzing the risk of an investment. It takes the historical annualized return and subtracts the risk free rate from it. This excess return is then divided by the standard deviation (which is seen in investing as a level of uncertainty or risk) to find how much excess return per

Comparing the investments in the chart above, an investor can use the standard deviation and correlation of returns to determine the given risk of the investments, as well as which investment choice would yield a better return. With the information provided a portfolio made up of equal parts B and C will ultimately be less risky than a

Capital Asset Pricing Model (CAPM) was developed in 1964 based on Modern Portfolio Theory. CAMP widely used in investment decisions and financial areas of the company. The main research of CAMP are the relationship between expected rate of return and risk assets in the stock market, as well as how the equilibrium price formation. In terms of the valuation of assets, CAPM primarily used to determine whether the securities market be mispricing. Capital Asset Pricing Model measure risk by non-diversified variance, it linked risk and expected return, any non-diversified risk assets can be described by the value of β, then calculate the expected rate of return. Rate of return required by investors is equals to the discount rate. The limitation of CAPM are: CAPM assumptions inconsistent with the actual; CAPM Should apply only to capital assets, human assets may not be traded; Estimated β coefficient represents the past of variation, but investors are concerned about the security volatility of future price; In the actual situation, the risk-free asset and the market portfolio may not exist.

Richard Roll, and University and Auburn, University of Washington, and University of Chicago educated economist, began his career researching the effect of major events of stock prices. This experience likely helped him reach the two conclusions he makes in his 1977 “A Critique Of The Asset Pricing Theory’s Tests”, one of the earliest and most influential arguments against CAPM. In the paper, Roll makes two major claims: that CAPM is actually a redundant equation that just further proves the concept of mean-variance efficiency, and that it is impossible to conclusively prove CAPM. His first claim relates to mean-variance efficiency: the idea that mathematically one must be able to create a portfolio that offers the most return for a given amount of risk. Roll claims that all CAPM is doing is testing a portfolio’s mean variance efficiency, and not actually modeling out projected future returns. The second claim in the paper is that there is not enough data about market returns for CAPM to ever prove conclusive. Even if modern technologies could help alleviate some of the burden of testing market returns for publicly traded equities, there is still no way to account for the returns of less liquid markets, where there is less public information. This means it is impossible for