Capm

1863 Words8 Pages
‘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.’

MN 3365
Strategic Finance
Table of Contents
Introduction
Concept of CAPM
Assumptions of CAPM .
Other Suggested Models
Disadvantages of CAPM
Advantages of CAPM
Problems in applying CAPM
Conclusion
Bibliography / References

INTRODUCTION

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
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The securities below the slope are overvalued stocks because for a given systematic risk the expectation is high . (Sharpe , 1964)
For example : The UK govt bonds is providing a return of 3% and the average market rate of return is 8.7% .The investor is expecting to invest in ABC ltd , listed in LSE .The beta calculated is 0.9 . Therfore on calculating , Rf = 3 , Rm = 8.7 , β = 0.9 . The return on investment comes out to be as 8.13 which is less than the rate of average market return . Therefore , it would not be beneficial to invest in shares of ABC Ltd .

Assumptions of CAPM .

William Sharpe presented several assumptions without which a valid CAPM cannot be obtained . These assumption are discussed below –
Investors hold diversified portfolios : One of the assumptions of CAPM model is that investors are holding only portfolios which are subjected to systematic risk , the unsystematic risk can be ignored , therefore the unsystematic risk has been ignored (Lakonishok & Shapiro , 1986)
Single period transaction horizon : To compare securities , a standarised holding period is assumed , therefore a one year return cannot be compared to a 6 months or 2 year return . Normally , a one year holding period is assumed . (Jouini, Koehl and Touzi, 1997)
Borrowing and lending can be done at a risk free rate of
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