The Capital Asset Pricing Model Essay

1565 WordsDec 29, 20167 Pages
Q.22: DISCUSS CAPM (WILLIAM SHARPE’S MODEL) WITH ITS ASSUMPTIONS. ALSO EXPLAIN THE CONCEPTS OF CML AND SML. (EXPLAIN THE SINGLE INDEX MODEL PROPOSED BY WILLIAM SHARPE.) ANS.: INTRODUCTION 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. The capital asset pricing model (CAPM) is a widely-used finance theory that establishes a linear relationship between the required return on an investment and risk. The model is based on the relationship between an asset 's beta, the risk-free rate (typically the Treasury bill rate) and the equity risk premium (expected return on the market minus the risk-free rate). This model was developed by William F. Sharpe (1990 Nobel Prize Winner in Economics) and John Lintner in 1960. The model attempts to capture market behavior. It is simple in concept and has real world applicability. The model is based on the promise that the systematic risk attached to a security is the same irrespective of any number by security in the portfolio. The total risk of the portfolio is reduced with increase in number of stocks as a result of decrease in the unsystematic risk distribution over number of stocks in portfolio. The CAPM is an alternative approach to the problem of measuring the cost of capital. This model attempts to measure the relationship between risk

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