Concept Of Capital Asset Pricing Model

“The Benefits of diversification are clear. Portfolio theory has played a crucial role in explaining the relationship between risk and return where more than one investment is held. It also enables us to identify optimal and efficient portfolios.”

Harry Markowitz 1991, developed a theory of “Portfolio choice”, that allows the investors to examine the risk as per the expected returns. In modern World, this theory is known as Modern portfolio theory (MPT). It attempts to attain the best portfolio expected return for a predefined portfolio risk, or to minimise the risk for the predefined expected returns, by a careful choice of assets. Though it’s a widely used theory, still has been challenged widely. The critics question the feasibility of theory as a strategy for

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.

CAPM tells how assets should be priced in the capital markets if, indeed, everyone behaved in the way portfolio theory suggests. The capital asset pricing model (CAPM) is a relationship explaining how assets should be priced in the capital market.

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

The author then sought to test the CAPM and FFM in terms of reliability to function and perform when used for different asset classes and in different market environments.

Having compared the differences, it is still worth noting that Markowitz did not rule out

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.

“Higher risks lead to higher returns” is one of the basic concepts in the investment theory. Also, the CAPM, thought for decades at universities as one of the basic asset pricing models, supports it.

(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

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.

However, Markowitz portfolio allocation theory is highly criticised, because the final portfolios are not adequately diversified. This model was applied to a South African market, so that it gives unrealistic portfolios, that are not diversified enough, as portfolio managers noticed (McLeod (1998).

This summary provides a brief overview of Capital Asset Pricing Model (CAPM) as an alternative method for estimating expected returns. This paper also discusses the positive and negative effects of CAPM along with the risks of Beta and why this model has its share of drawbacks and critics in the marketplace. The first section will cover the basics of CAPM including its flaws and rewards. Next, the risks of beta and the strengths and weaknesses are discussed in conjunction with its relevance to CAPM and why it’s important to investors who are willing to take greater risks. Finally, an application is provided to show how beta affects CAPM from a financial manager’s perspective.

This paper aims to analyze the validity of the CAPM model of predicting returns for stocks by empirically testing the model with past financial data. The CAPM model is defined as R_i=r_f+ β_i (R_m-r_f). R_i represents the return on stock i, and is what the CAPM model attempts to define or predict. r_f represents the risk free rate available at the time the model is being analyzed, a figure that’s important for understanding both minimum return figures and the return premium offered by the market. β_i represents the Beta of stock i and is a measure of a given company’s volatility relative to the market they are in. If β_i is one, then the company is at market risk, if it is lower than one then it is below market risk, and if it is higher than one then it is above market risk. The only stock that would have a Beta of 0 would be a risk free stock, or whatever security you are using for your risk free rate. β_i is calculated as (COVARIANCE(r_i-r_f,〖 r〗_m-r_f))/(VARIANCE(〖 r〗_m-r_f)).(R_m-r_f) represents the Market Risk Premium, or the level of return an average stock in the market would return in excess of the risk free rate.

Modern portfolio theory is an investment theory based on that investors can construct portfolio to maximize return which based on a given level of market risk, emphasizing that risk is an essential part of higher return. Modern portfolio theory is one of the most significant economic theory dealing with finance and investment, which was published by Harry Markowitz in his paper “Portfolio Selection” in 1952 by Journal of Finance (Shipway, 2009).