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Critically Evaluate the Role of the CAPM in the Modern Asset Pricing Literature

Critically Evaluate the Role of the CAPM in the Modern Asset Pricing Literature

Introduction

The aim of this essay is to critically evaluate the role of the CAPM in the modern asset pricing literature. One of the major concerns in the field of finance has been to develop explanatory and predictive models of the behaviour of financial assets. One of the most important contributions to this process has been the Capital Asset Pricing Model (CAPM). The model explains the behaviour of a stock based on market behaviour. One of the contributions of the CAPM is the relationship established between the risks of a return to action. It is shown that the variance of an action, by itself is not important to determine the expected return of the action. What is important is to measure the degree of co-variability on a standard measure of risk, which corresponds to the market. It is the market beta of the action, which measures the covariance of the return of the action on the market index return, resized by the variance of the index.

The model of CAPM (Capital Asset Pricing Model) is used in finance to determine the appropriate theoretical rate of return for a particular asset in relation to a portfolio in a diversified market. The sensitivity of assets to the market risk is also taken in to account in this model. The market risk is represented by the beta version of the quantity index. On the other hand, the expected return and the expected return on market are presented as theoretical risk free assets (Perold, 2004).

Discussion and Analysis

According to the CAPM, the cost of capital is the rate of return required by investors as compensation for the market risk to which they are exposed. The CAPM considers that in a competitive market, the risk premium varies in proportion to ß. It has been presented in the simplest form of the model that the expected return on risk free rate is proportional to the non-diversifiable risk. The risk premium is measured in the model buy the co variance of all assets with the return on all assets or by the market risk. All investors have identical expectations about the means, variances and co-variances of returns from different assets at end of period, i.e. have homogeneous expectations regarding the joint distribution of returns.

Capital Assets Pricing Model describes the pricing of risky securities by estimating the risk with the expected return. It is founded on the assumption that the investor has an aversion to high risk factors. The CAPM is one of the ways of estimating the cost of equity. It has many advantages for estimating the cost of equity but at the same time it has several disadvantages. Like it does not measure the market risks. The formula for Capital Asset Pricing Model is given below

ra = rf + ßa(rm-rf)

Where,

rf = Risk Free Rate

ßa = Beta of the security

rm = Expected Market ...

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