The Capital Asset Pricing Model Essay

In this literate review the most important papers about explaining stock returns from 1952, when Markowitz came up with Modern Portfolio Theory, till around 2011 will be discussed. As stated in Chapter 2, Jack Treynor was one of the first economists that started to work on the CAPM model. When he developed the CAPM in 1961, there was no way yet to fully test it. Because there were no samples large enough or of sufficient quality, the real testing of the CAPM started in 1970. In 1973, the world was shown the famous Black and Scholes options pricing model. One of the first studies that gave a different answer than the CAPM was the research by Basu (1977). While he agrees with the Efficient Market Hypothesis, Basu reaches another

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 relationship between risk and rate of return is risk determines expected rates of return on every existing asset investment. The Risk-Return relationship is characterized as being a "positive" or "direct" relationship. (Importance of risk relationship , 2001). In other worlds if the risk of investing on an investment is high then the return will also be high.. Alternatively, if an investment has relatively lower levels of expected risk then the investor will get relatively lower

The analysis of this paper will derive the validity of the Fama and French (FF) model and the efficiency of the Capital Asset Pricing Model (CAPM). The comparison of the Fama and French Model and CAPM (Sharpe, 1964 & Lintner, 1965) uses real time data of stock market to practise its efficacy. The implication of the function in realistic conditions would justify the utility of the CAPM theory. The theory suggests that the expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the expected return on the market portfolio, the variance of the return on the market portfolio, and

Capital asset pricing model know as CAPM is a model for calculates the required rate of return for any risky asset. This method is often used to determine the fair price of an investment should be. This essay will discuss about usage of CAPM in stock market industry, through probe the advantages and limitation of CAPM to this industry.

Still, CAPM remains to be used, or is adjusted to in order to fix anomalies; and to study empirical behaviour in the market. In adjusting the CAPM for anomalies, additional factors such as earnings yield (Basu, 1977), firm size (Banz, 1981), the firm’s ratio of book value of equity to its market value (Chan et al, 1991), leverage (Bhandari, 1988), stock liquidity (Amihud and Mendelson, 1986), and stock price momentum (Jegadeesh and Titman, 1993) are being used in describing the distribution of asset returns (Dempsey, 2013). Among these asset pricing models is the FFM.

The main message of the Capital Asset Pricing Model (CAPM) attempts to find value in financial assets by connecting an asset's return and its risk. It is a simple analytical tool used to find a rather straightforward and simple question: How much risk is contained in this investment?

Firm has a range of projects to be invested in or finance in to increase the value of the company. However, to increase the value of the company, firm need to choose the worth pursuing project. In this case, firm need to evaluate the projects which the evaluation of a project can be done by cash flow method.

On the other hand, Capital Asset Pricing Model explains how individual securities are valued, or priced, in efficient capital markets (Pike et al., 2012). This involves discounting the future expected returns from holding a security at a rate that adequately reflects the degree of risk incurred in holding the security. CAPM shows that only risk premium will be related to systematic or non-diversifiable risk.

This essay is mainly focused on Capital Asset Pricing Model (CAPM) and how beta (measure of volatility) influences investment decisions. Nevertheless, how much we diversify our investments, it 's impossible to get rid of all the risk. As investors, we deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM) helps to compute the investment risk and expected returns. Throughout in depth analysis of CAPM model discussed in this essay, we will be looking how beta influences investment decisions and what are the risk associated with different industries. Moreover, how to minimise risk and what are different types of risks involved when investing in different portfolios. This essay is written to critique the ability of a portfolio investment combatting risk as a whole.

Capital market has deep developed this century, more and more investors go into this market. Which security is better? How to invest? Investors need numeric index to make decision. There are some theories to help investors: portfolio theory, capital asset pricing model (CAPM), option pricing model and so on. This essay will explain portfolio theory firstly. Secondly, this essay will explain CAPM and discuss the importance of the assumptions of CAPM. Thirdly, this essay will explain arbitrage pricing theory (APT) and factors model. Finally, this essay will compare CAPM with APT and factors model.

The CAPM bases the required rate of return on equity of a company based on an assumption of linearity between the level of risk a security carries and its returns. Variance has been widely used as a measure of risk, usually represented as the standard deviation of the returns of a given security. The relationship of risk and reward is the product of the security’s covariance divided by the covariance of the market,

Despite this, however, some have since suggested that their model is pure economics, and is only valid in a theoretical world that doesn’t reflect some of the frictions that actual financial markets do.

In 1959, Markowitz laid a portfolio theory where he introduced mean-variance efficient portfolio that explained minimum variance for given expected return and maximum return for given variance. This revolutionized the finance field and provided groundwork for Capital Asset Pricing Model (CAPM) founded by William F. Sharpe (1964) and John Lintner (1965). Sharpe and Lintner showed that when investors hold mean-variance efficient portfolio and expect homogeneously, then even in absence of market fluctuations the portfolio formed would itself be mean-variance efficient portfolio.

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