Capital Asset Price Model

Capital Asset Price Model

[Word Count 2067]Capital Asset Price Model

Introduction

The capital asset charge form (CAPM) is a theory of the connection between the risks of a security or a portfolio of securities and the anticipated rate of come back that is commensurate with that risk. The theory is based on the assumption that security markets are efficient and dominated by risk adverse investors. In other phrases, the CAPM argues that investors are willing to take on more risk only if they can reasonably expect a higher return.

The CAPM accepts the risk/return trade-off financial standard and quantifies that trade-off.

Further, the model assumes that most investors diversify their investment holdings so as to not put .all of their eggs in one basket. Indeed, the tendency for investors to diversify their buying into portfolios suggests that, in a CAPM context, the only kind of risk that is paid or applicable in the risk/return trade-off is methodical or market-related risk. Thus, the additional risk conceived by not diversifying amidst investments is not paid by the securities markets under the CAPM.

The discernable connection between risk and expected return in the CAPM is summarized by the following expression:

Rt = Rf + ßi [ Rm - Rf ]

Consider a demonstration of how the CAPM approximates the appropriate risk-adjusted anticipated come back on an investment. Assume that the risk-free rate of come back on a U.S. Treasury bond is 7%, the expected return on the market is 15%, and that and shareholder wants to work out the appropriate anticipated rate of return on a supply with a beta of 1.5. The market-wide risk premium is (15% - 7%) or 8%. Thus, a stock with a beta of 1.5 should generate an anticipated come back of 19% in order to amply compensate investors for the above-market risk of the investment.

Assumptions under CAPM

There are many investors. They act competitively (price Takers). All investors are looking ahead over the same (one period) designing horizon. All investors have identical access to all securities. No taxes and no commission.

Issues in CAPM

Problems can arise when using the CAPM to calculate a project-specific discount rate. For example, one common difficulty is finding suitable proxy betas, since proxy companies very rarely undertake only one business activity. The proxy beta for a proposed investment project must be disentangled from the company's equity beta. One way to do this is to treat the equity beta as an average of the betas of several different areas of proxy company activity, weighted by the relative share of the proxy company market value arising from each activity. However, information about relative shares of proxy company market value may be quite difficult to obtain.

A similar difficulty is that the unhearing of proxy company betas uses capital structure information that may not be readily available.

Critical analysis

The asset-pricing model has been subject of several academic papers; it is still revealed to theatrical and empirical criticism. For example Miller and Scholes (1972) have considered the statistical problem inherent in the empirical investigations of ...