Consider Capital Asset Pricing Model

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Name: Li XU Morning group: PGA15 Project group: Management 02 Date: 30/08/2016

Consider the capital asset pricing model. What are the theoretical underpinnings of this model? What can you say about the empirical implications of this model?

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
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At the beginning of the discussion, definition of CAPM will be introduced. The CAPM is an essential model in financial management, it makes contributions to establishing the foundation of modern financial theory and research. This model based on two important lines.

The capital market line (CML) represents the risk-return combinations for investors to choose the best investment portfolio with the risk-free asset in an efficient market. It defines the risk/return trade-off for efficient portfolios. The risk of this equation is all systematic risk (Pike et al, 2012).

The security market line (SML) consists of the return of a risk-free asset and a premium risk which related to the market’s own risk premium. This equation shows the expected rate of return of an individual security and the risk is measured by beta (Pike et al, 2012).

The beta is a measure of risk arising which indicates whether the investment is more or less unstable than the market. The greater the beta that shows a particular security, the higher the expected returns of the security (McLaney, 2006).

All the theoretical underpinnings rely on the assumptions. The CAPM is always regarded as an unrealistic model because the assumptions which the theory bases on are difficult to satisfy, so it is necessary to understand these assumptions and explain why they are always criticised by economists.

Now, these factors mentioned above will be explained more specifically. There are six
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