‘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
*…show more content…*

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

Related

- Better Essays
## Capm: Capital Asset Pricing Model

- 1407 Words
- 6 Pages

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.

- 1407 Words
- 6 Pages

Better Essays - Decent Essays
## Literature Review: The CAPM As An Asset Estricing Model

- 907 Words
- 4 Pages

In the literature review, the author states that the CAPM has been the most favoured asset pricing model used since the 1960s. The CAPM though, has been questioned and its misspecifications identified since the 1970s, as the CAPM was unable to explain the risk measure and returns difference.

- 907 Words
- 4 Pages

Decent Essays - Satisfactory Essays
## CAPM And Factor Models Project Essay

- 1640 Words
- 7 Pages

It does not describe the process by which equilibrium is achieved; i.e., the process by which agents buy and sell securities, in their desire to hold efficient portfolios, thereby altering security prices and expected returns and thus requiring further changes in portfolio composition. The CAPM describes the situation after this trading process is over and investors are optimizing given the prevailing prices.

- 1640 Words
- 7 Pages

Satisfactory Essays - Better Essays
## Capital Market Analysis: a Dicussion on Efficient Market Hypothesis

- 3408 Words
- 14 Pages

Moreover, there are some cross-sectional predictable patterns, such as ¡®Value Stocks appear to provide higher rates of return than stocks with high price-to-earnings ratios¡¯ when accepting CAPM, Malkiel argues that the finding does not necessarily imply inefficiency of the financial market, it may only indicate failure of the CAPM to capture all dimensions of risk.

- 3408 Words
- 14 Pages

Better Essays - Better Essays
## The Behavioral Finance Paradigm And Its Derived Explanations Of Stock Market Bubbles And Crashes

- 2940 Words
- 12 Pages

In this trend, there are several models to support this view of these investors, including the Modern Portfolio Theory (MPT), Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) (Fama and French, 2004; Perold, 2004). They have been the main instruments that the rational expectation based theories have been deploying. However, this traditional paradigm has been analyzed by a number of researches that the information should not be considered to have a very important role in affecting investors (Miles and McCue, 1984), Titman and Warga (1986), Lusht (1988) and Liu and Mei (1992).

- 2940 Words
- 12 Pages

Better Essays - Good Essays
## Relationship Between Risk And Rate Of Return Performance

- 1416 Words
- 6 Pages

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

- 1416 Words
- 6 Pages

Good Essays - Best Essays
## Asset Pricing And Portfolio Management Models

- 2077 Words
- 9 Pages

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”)

- 2077 Words
- 9 Pages

Best Essays - Better Essays
## Capm vs. Apt: an Empirical Analysis

- 6429 Words
- 26 Pages

The Capital Asset Pricing Model (CAPM), was first developed by William Sharpe (1964), and later extended and clarified by John Lintner (1965) and Fischer Black (1972). Four decades after the birth of this model, CAPM is still accepted as an appropriate technique for evaluating financial assets and retains an important place in both academic scholars and finance practitioners. It is used to estimate cost of capital for firms, evaluating the performance of managed portfolios and also to determine asset prices. Since the inception of this model there have been numerous researches and empirical testing to assess the strength and the validity of the model.

- 6429 Words
- 26 Pages

Better Essays - Better Essays
## Capital Asset Pricing Model ( Capm ) And How It Can Be Used By Fund

- 2213 Words
- 9 Pages

This paper looks at The Capital Asset Pricing Model (CAPM) and how it can be used by fund

- 2213 Words
- 9 Pages

Better Essays - Better Essays
## Relationship Between Chinese Stock Market And Macro Economy

- 2300 Words
- 10 Pages

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

- 2300 Words
- 10 Pages

Better Essays - Better Essays
## The Capital Asset Pricing Model

- 1034 Words
- 5 Pages

The Capital Asset Pricing Model (“CAPM”) was introduced by Sharpe (1964), Lintner (1965) and Mossin (1966) to provide investor an understanding in relation to the expected returns of their investment. However, this theory has been criticised by some empirical models resulted from the unrealistic assumptions. This paper will critically analyse the limitation of the CAPM and will discuss Arbitrage Pricing Theory (“APT”) and Fama-French (“FF”) Three-Factor Model (“TFM”) as the possible alternative empirical approaches.

- 1034 Words
- 5 Pages

Better Essays - Better Essays
## Capital Asset Pricing Model (Capm)

- 2553 Words
- 11 Pages

Capital asset pricing has always been an active area in the finance literature. Capital Asset Pricing Model (CAPM) is one of the economic models used to determine the market price for risk and the appropriate measure of risk for a single asset. The CAPM shows that the equilibrium rates of return on all risky assets are function of their covariance with the market portfolio. This theory helps us understand why expected returns change through time. Furthermore, this model is developed in a hypothetical world with many assumptions.

- 2553 Words
- 11 Pages

Better Essays - Better Essays
## KazMunaiGas Exploration Production Company Analisys Essay example

- 4847 Words
- 20 Pages

Fama, E.F. & French, K.R. (2004). The Capital Asset Pricing Model: theory and evidence. Journal of Economic Perspectives 18 (3).

- 4847 Words
- 20 Pages

Better Essays - Satisfactory Essays
## 5.1 INTRODUCTION In order to prove the validity of CAPM model in Indian Stock Market Fama and

- 700 Words
- 3 Pages

In order to prove the validity of CAPM model in Indian Stock Market Fama and MacBeth’s traditional approach was used as the model to prove the hypothesis. The analysis period is taken from year starting 1st January, 1999 to 31st December 2013, a total time period of 15 years. This period was divided into seven 9-year sub-periods with eight overlapping period. The periods are been continuously overlapped to reduce the variability of the beta co-efficient that were estimated.

- 700 Words
- 3 Pages

Satisfactory Essays - Better Essays
## Capital Asset Pricing Model

- 1781 Words
- 8 Pages

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:

- 1781 Words
- 8 Pages

Better Essays