Capital Asset Pricing Model - CAPM

It shows the relationship between expected return and systematic risk of individual asset or securities or portfolios�

1. CAPITAL ASSET PRICING MODEL- CAPM BY: ARVINDER PAL KAUR FACULTY OF MANAGEMENT NWGOI, DHUDIKE MOGA

2. CAPM CAPM refers to Capital Asset Pricing Model. CAPM was introduced by William F Sharpe. CAPM is a framework for determining the Equilibrium expected return for risky assets. It shows the relationship between expected return and systematic risk of individual asset or securities or portfolios. It emphasize that risk factor in portfolio theory is a combination of two risks- Systematic risk and unsystematic risk.

3. ASSUMPTIONS CAPM model relies on following Assumptions that ALL INVESTORS: Aim to maximize economic utilities. Are rational and risk-averse. Are broadly diversified across a range of investments. Are price takers, i.e., they cannot influence prices. Can lend and borrow unlimited amounts under risk free rate of interest. Have homogenous expectations. No transaction cost.

4. Concept The CAPM is a model for pricing an individual security or portfolio. For individual securities, we make use of Security Market Line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market.

5. Formula CAPM : E(R i ) = R f + B i {E(R m ) – R f } Where: E(R i ) is expected return on the capital asset R f is the risk free rate of interest. B i (the Beta) E(R m ) is the expected return of the market. E(R m ) – R f is sometimes known as the market premium (the difference between the expected market rate of return and the risk free rate of return)

6. Asset Pricing Once the expected/required rate of return E(R i ) is calculated using CAPM, we can compare this required rate of return to the asset’s estimated rate of return over a specific investment horizon to determine whether it would be an appropriate investment or not.

7. Problems of CAPM This model is based on vague and inappropriate assumptions. The model wrongly assumes that all active and potential shareholders have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption) The model does not appear to adequately explain the variation in stock returns.