Capital Asset Pricing Model and Arbitrage Pricing Theory

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.

‘The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the industry even though it is based on very strong assumptions. Discuss in the light of recent developments in the area.’

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.

(1) Capital Asset Pricing Model (CAPM): This model says that the expected return of a security or a portfolio is equivalent to the rate on the risk-free security plus a risk premium. If the expected return does not meet or exceed the required return, the investment should not be made. We used this CAPM to estimate the cost of capital for Ameritrade. The CAPM formula is Ri = Rf + βi* (RM-Rf) where Rf = the rate of return for a risk-free security, RM = the

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 capital asset pricing model (CAPM) was proposed by Sharpe (1964) –Lintner (1965) whom had relied on the Markowitz mean–variance-efficiency model, in the mean – variance –efficiency model investors are supposed to be risk-averse during one time period and they only care about the expected returns and the variance of returns (risk). These investors choose only efficient portfolios with minimum variance, given expected return, and maximum expected return, and variance. The Expected returns and variance plot a parabola, and points above its global minimum identify a mean–Variance - efficient frontier of risky assets.

The main message of the Capital Asset Pricing Model (CAPM) attempts to find value in financial assets by connecting an asset's return and its risk. It is a simple analytical tool used to find a rather straightforward and simple question: How much risk is contained in this investment?

According to investment glossaries, a risk is a future probability of loss inherent in any investment (Investopedia Financial Dictionary, 2016). To this day, the positive correlation between risk and return continues to be the cornerstone of financial theory. The basic capital asset pricing model (CAPM) formula is built on this relationship. CAPM provides the required return based on the level of systematic risk of an investment. The risk associated with an investment is taken to lie along a scale. On the low-risk end of the scale, there are low yielding government bonds and securities. At the middle of the spectrum are medium performing investments – such as high yielding loan notes, and rental property. At the far end of the scale – high-risk – are futures, options, and equity investments. However, the positive relationship between risk and return does not guarantee that taking a greater risk will result in higher returns. Rather, a higher risk may lead to the loss of a greater amount of capital. This paper seeks to examine the risk and return relationship and how investors can determine the optimal trade-off.

Ever wonder if generating alpha is a zero-sum game or if quotes like the below hold:

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

Capital Asset Pricing Model is the foundation stone of modern finance theory. It reveals the basic operation rules of the capital market and it is important in market practice and theory research(). By use of this model, the relation between risk and expected return is accurately predicted, and provides a method to estimate the yield of potential investment projects and help us to predict the expected rate of return of market in future. Although the Capital Asset Pricing Model is not entirely consistent with the empirical test, however, because of the simplicity of the model, it is still widely used. A model may have highly realistic assumptions, but if it has no predictive power, it is largely worthless. Most researchers have attempted to test the CAPM to see if it works, looking at the relationship between observed beta values and average returns(). One phenomenon is that the actual slope of the Security Market Line is slightly less than the predicted slope of the CAPM. This essay is going to discuss potential explanations of this phenomenon.

We use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. As

Both the Capital Asset Pricing Model and the Arbitrage Pricing Model rest on the assumption that investors are reward with non-zero return for undertaking two activities: