The Capital Asset Pricing Model.docx

The Capital Asset Pricing Model (CAPM) represents an important breakthrough in finance theory. It was developed independently by Sharpe (1964), Lintner (1965), Treynor and Black, and built on preparatory portfolio work by Markowitz (1952) and Tobin. It is a straightforward, yet elegant model that relates an asset’s expected return to its risk. The CAPM is one of the key concepts in modern finance and thoroughly researched by academics. It is widely used by financial managers and analysts to establish required rates of return and the cost of capital for different types of investments and finance decisions. The CAPM draws on a particular classification of risk: (i) systematic (or market) risk, which is the tendency of a stock to move together with the general stock market, and (ii) non-systematic risk, which reflects firm-unique factors. The former type is also called “non-diversifiable risk,” the latter “diversifiable risk.” By holding a large number of stocks and other assets, investors can eliminate firm-specific risk factors. Because of asset diversification, the standard deviation of a portfolio is often less than the standard deviation of the individual assets in the portfolio. Although diversification can eliminate firm-specific risk, it cannot eliminate overall market risk. For an efficiently designed and diversified portfolio the only relevant risk that remains is systematic risk. Hence, CAPM’s core idea is that investors can expect a reward for a particular investment’s contribution to the risk of a portfolio with higher rewards (returns) for investments that have a larger element of non-diversifiable risk. However, no reward can be expected for exposure to risks that can be easily diversified away. The capital asset pricing model is based on simplifying assumptions, of which can be expressed as follows: The first assumption is that Invest or purpose is the maximizing of expected utility from final wealth. Second, all investors have homogeneous expects about the risk/reward trade-offs in the market. The third assumption is that Information simultaneously and freely available to all investors and investors can’t be affected stock prices by buying and selling stock. The fourth assumption is that Taxes, transaction costs, there is no limit to short sell or other market constraints. Investors are considered to maintain diversified portfolios, as the market does not reward investors for bearing diversifiable risk. Consequently, the CAPM implies that if a security’s beta is known, it may to calculate the parallel expected return. The relationship is known as the Security Market Line (SML) equation and the measure of systematic risk in the CAPM is called Beta.

The formula for CAMP is E (Ri) = Rf +βj (E(Rm) - Rf But CAPM can be modified to include size premium and specific risk. This is important for investors in privately held companies who often do not hold a well-diversified portfolio. The equation is similar to the traditional CAPM equation “with the market risk premium replaced by the product of beta times the market risk premium:”

E (Ri) = Rf + (RPm) +RPs+ RPu “where: E(Ri) is required return on security i Rf is risk-free rate RPm is general market risk premium RPs is risk premium for small size RPu is risk premium due to company-specific risk factor

In the CAPM, the key variable is the beta coefficient, which measures the degree of market risk. It reflects the change in an asset’s return in response to a change in the overall market return. It is thus a (relative) measure of volatility. The beta for an individual asset is estimated on the basis of historical data, using regression analysis of the returns of the asset in a particular period against the returns of a suitable market return. For future applications, therefore, the beta and the required return should only be regarded as estimations. In the freely competitive financial markets described by CAPM, no security can sell for long at prices low enough to yield more than its appropriate return on the SML. The security would then be very attractive compared with other securities of similar risk, and investors would bid its price up until its expected return fell to the appropriate position on the SML. Conversely, investors would sell off any stock selling at a price high enough to put its expected return below its appropriate position. The resulting reduction in price would continue until the stock’s expected return rose to the level justified by its systematic risk.

(An arbitrage pricing adjustment mechanism alone may be sufficient to justify the SML relationship with less restrictive assumptions than the traditional CAPM. The SML, therefore, can be derived from other models than CAPM.2) One perhaps counterintuitive aspect of CAPM involves a stock exhibiting great total risk but very little systematic risk. An example might be a company in the very chancy business of exploring for precious metals. Viewed in isolation the company would appear very risky, but most of its total risk is unsystematic and can be diversified away. The well-diversified CAPM investor would view the stock as a low-risk security. In the SML the stock’s low beta would lead to a low risk premium. Despite the stock’s high level of total risk, the market would price it to yield a low expected return. In conclusion, The CAPM’s key outcome – a required return – represents thus a market-based opportunity “cost” that reflects risk similar to the asset under scrutiny. Well-known alternative financial models to estimate this return include the Gordon Constant-Growth Model ,which focuses on a firm’s dividends; the Arbitrage Pricing Theory (Ross, 1976), which uses multiple economic factors instead of the market portfolio; to explain expected returns.

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