Capital Asset Pricing Model and Arbitrage Pricing Theory Essay examples

Advantages of CAPM: Easy to calculate, takes systematic market risk into account, and ability to provide a precise estimate of cost of equity.

In capital market, people are always seeking for the best investment project. They want to use the least cost to earn the most money. In another way, people always try to find the connection between the risk of an investment and its expected return. Nowadays, the most widely used model is CAPM. CAPM is Capital Asset Pricing Model. CAPM was funded by Jack Treynor (1962), William Sharpe (1964), John Lintner (1965a, b) and Jan Mossin (1966) (Dempsey, 2013). And it is the birth of asset pricing theory. The term ‘CAPM’ illustrates that it can give a proper solution to find the connection between risk and the expected return of the market portfolio under uncertainty conditions (Brealey, Myers and Allen, 2011). It is important for some researchers to help their decision making in capital market. This essay contains four parts. This essay examines firstly is giving a summary theory of CAPM. The second part will talk about the CAPM’s uses and limitations in evaluating the potential investment in a firm’s shares. The third part will talk about limitations and how CAPM to be used as a source of discount rate in capital budgeting for the firm’s direct investments. The forth part will give a conclusion about this essay.

CAPM is a model that describes the relationship between risk and expected return, and the formula itself measures the expected return of the portfolio. Mathematically, when beta is higher, meaning the portfolio has more systematic risk (in comparison to the market portfolio), the formula yields a higher expected return for the portfolio (since it is multiplied by the risk premium and is added to the risk free interest rate). This makes sense because the portfolio needs to

The goal of this paper is to explain why CCM’s aggressive program is a good alternative to any investor looking to diversify its portfolio. The paper will be divided into three distinct parts: the operational analysis, the quantitative analysis and a comparison against its peers (including the impact of CCM in a traditional portfolio).

The Capital Assets Price Model (CAPM), is a model for pricing an individual security or a portfolio. Its basic function is to describe the relationship between risk and expected return, which is often used to estimate a cost of equity (Wikipedia, 2009). It serves as a model for determining the discount rate which is used in calculating net present value. The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. The formula is:

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

In order to test the validity of the CAPM, we have applied the two-step testing procedure for asset pricing model as proposed by Fama and Macbeth (1973) in their seminal paper.

Even though there are flaws in the CAPM for empirical study, the approach of the linearity of expected return and risk is readily relevant. As Fama & French (2004:20) stated “… Markowitz’s portfolio model … is nevertheless a theoretical tour de force.” It could be seen that the study of this paper may possibly justify Fama & French’s study that stated the CAPM is insufficient in interpreting the expected return with respect to risk. This is due to the failure of considering the other market factors that would affect the stock price.

Furthermore, the CAPM is only a single-period model. Critics mention that estimates for the risk-free rate, market return and beta factor, are difficult to accurately determine in real-life. The assumption that diversifiable risk is not taken in consideration does not work well for investors that do not have a well-diversified portfolio. CAPM therefore overlooks unsystematic risk, which may be of importance to investors who do not have a diversified portfolio. The CAPM’s validity is due to difficulties in applying valid tests of the model. CAPM states that “the risk of a stock should be measured relative to a comprehensive “market portfolio” that in principle can include not just traded financial assets, but also consumer durables, real estate and human capital” (Hill, 2014). Even though CAPM is widely used in the corporate world, according to Fama and French (2004), CAPM has never been an empirical success (p.43). Researchers found variables like size, various price ratios and momentum that affects the average returns provided by beta (Fame and French, 2004, p.43). The issues addressed in the studies were serious enough to invalidate most applications of the CAPM (Fama and French, 2004, p.43). According to Wu (2007), the only economic prediction of CAPM is that the market portfolio is mean-variance efficient. In study cited by Wu (2007), Roll argues that a “true market portfolio should include all

The Capital Asset Pricing Model (CAPM) the company, can measure each stock according to my market portfolio (Bringham & Ehrhardt, 2014). The CAPM calculated to be nearly 24% and the high market risk of 14. All investors focus on holding period, and they seek to maximize the expected utility of their terminal wealth by choosing among alternatives portfolio 's expected return and standard deviation. All

According to Brealey et al. (2001) the capital asset pricing model (CAPM) is the theory based on correlation among risk and return which indicates that asset 's beta multiplied by risk premium of market will show the expected risk premium on the market portfolio. Similarly, Megginson et al. (2007) confirm that the major idea of the capital asset pricing model (CAPM) is to point out that required return of the security is risk free rate plus risk premium. Thus, investors demand expected return on their investments based on the risk and return relationship of assets (Brealey et al., 2001). Moreover, according to Megginson et al. (2007) the mathematical formula for determining the expected rate of return on long-term asset is as follows:

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

The CAPM (capital asset pricing model) is a model used to evaluate a theoretically appropriate required rate of return of an asset in finance field, providing information to investor to make decisions about investment portfolios and guide investors’ investment behaviours (McLaney, 2006). The CAPM was invented by William F. Sharpe, John Lintner and Jan Mossin, basing on the earlier work of Harry Markowitz on diversification and modern portfolio theory, and now it is universally applied (Vernimmen, et

Therefore, look for other variables that will explain EXPECTED RETURN (the dependent variable, the y