Capital Asset Pricing Model ( Capm )

“99 percent of all statistics only tell 49 percent of the story.”- Ron DeLegge II (former investment advisor and weekly voice of the Index Investing Radio Show).

Capital asset pricing model or CAPM is a financial model that measures the risk premium inherent in equity investments like common stocks while Discounted Cash Flow or DCF compares the cost of an investment with the present value of future cash flows generated by the investment with the mindset being that if the cash flow is positive, then the investment is good. Generally speaking, CAPM is a model that describes the relationship between risk and expected return and DCF is a valuation method used to estimate the attractiveness of an investment opportunity. So what are the differences, advantages and disadvantages of each one? How

The EMH supposes that the capital market should be a level game for all players. Herein, all information consequential to an investor’s decision is incorporated in determination and fixation of share prices. This is irrespective of whether it has been made public or not, as long as any single investor is aware of its existence. As such there is no chance of overpricing or underprizing of shares (Gili, Cheng-few & Basin 2008). With any new information, the change is instantly effected. Prediction, according to the premise, is a mere episode of chance. Today, some of the world’s business moguls have seemingly done the impossible by overtaking the market alteration. This has made them reap great benefits from capital market trading and obviously evoked doubts on the authenticity of this proposition.

There is only one reason investors receive higher returns make that investment in high-risk stocks. Therefore, CAPM occupy dominant position in this modern financial environment (Fama and French, 1993).

CAPM on the other hand is based on microeconomic ideas such as concave utilities and costless diversification. Macroeconomic events mentioned include interest rates or the cost of labor, causes the systematic risk that affects the returns of all stocks. On the other hand the firm-specific events are the unexpected microeconomic events that affect the returns of specific firms for example the death of key people that would affects the firm, but would have a insignificant effect on the

The important implication of this is that investors cannot consistently outperform the market, and if they do it is purely through luck. With competition for information reaching new heights, professional managers face greater difficulties in attempting to outperform each other. If these professionals are unable to consistently beat the market, there remains little hope for the average investor.

Even though the CAPM still is relevant, several empirical tests have figured out a flatter SML than expected as well as a contrary return-beta relationship. Researchers have tried to explain this anomaly. One is the betting against beta factor mentioned by Frazzini and Pedersen and should be discussed in this essay.

The CAPM bases the required rate of return on equity of a company based on an assumption of linearity between the level of risk a security carries and its returns. Variance has been widely used as a measure of risk, usually represented as the standard deviation of the returns of a given security. The relationship of risk and reward is the product of the security’s covariance divided by the covariance of the market,

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

There are many different asset pricing and portfolio management models available to assist us in the estimation and evaluation of a stock’s return. The Fama-French Model (“FFM”) is one of those models. Kenneth French and Eugene Fama who were professors at the University of Chicago Booth School of Business designed the FFM. Kenneth French and Eugene Fama observed that historically, the Capital Asset Pricing Model (“CAPM”), which was predominantly used, was inaccurate as it often resulted in high alpha values which meant that a huge portion of excess returns were left unexplained. They also observed that companies with smaller market caps would outperform companies with higher market caps and companies with higher book-to-market (“B/E”)

CAPM is simple period model that demonstrates the linear relationship between systematic risk of an asset and expected market return. The formula of CAPM is

Capital market has deep developed this century, more and more investors go into this market. Which security is better? How to invest? Investors need numeric index to make decision. There are some theories to help investors: portfolio theory, capital asset pricing model (CAPM), option pricing model and so on. This essay will explain portfolio theory firstly. Secondly, this essay will explain CAPM and discuss the importance of the assumptions of CAPM. Thirdly, this essay will explain arbitrage pricing theory (APT) and factors model. Finally, this essay will compare CAPM with APT and factors model.

The CAPM model was developed by Sharpe (1964) to explain how capital markets set share prices. (Pike and Neale) In result of research by Sharpe (1964), Litner (1965) and Black (1972) the Capital Asset Pricing Model (CAPM) states “the relationship between beta (measure of volatility on portfolios/assets) and expected returns is linear, exact, and has a slope equal to the expectation of the market portfolio excess return”. CAPM makes the assumption that markets are efficient therefore suggesting that operators within the market have rational expectations, this assumption leads us to the first weakness of CAPM (Vernimmen, 2011). However, when estimating the cost of capital, CAPM is seen to be preferred compared to other asset pricing models simply due to its simplicity. In a survey conducted by the Association for Financial Professionals (2011) it was found that when estimating the cost of capital 87% of all firms and 91% of publicly traded firms used CAPM.

Even though many articles are conducted to critically study the capital asset pricing model ( CAPM ), it is widely used around financial

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