Economics Of Corporate Finance Theory

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Economics of Corporate Finance

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.

Most researchers test the CAPM by the basis of ‘risk premiums’, and the model is: E[R_i ]= r_f+β_i (E[R_Mkt ]- r_f), then it minus the risk-free return from both side and add an intercept term-α into this model, the intercept term should be zero, we can see new equation: E[R_i ]- r_f= α+β_i (E[R_Mkt ]- r_f). In this model, the beta is used to measure the systematic risk between investment and stock
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