Capital Asset Pricing Model Essay

1391 Words3 Pages
bulb-icon

Recommended: Essays on capital assets pricing model

CAPM is standing for Capital Asset Pricing Model which helps investors to calculate investment risk and also evaluate portfolio’s rate of return. It is based on the Markowit’s mean-variance theory. Capital asset pricing model is an equilibrium model which can be used to explain the relationship between the systematic risk and the expected return of a portfolio. The capital asset includes bond, stock, securities and etc. This essay will be divided into three parts. First of all, the capital asset pricing model will be fully introduced and the components of CAPM will also be explained. In addition, it is going to illustrate the security market line(SML) which indicates the relationship between risk and expected return by graph. Secondly, the …show more content…

The graph shows when beta coefficient is 0, the expected return is the risk-free rate(3.5). With a beta coefficient of 1, the expected return is 8. It also has a beta of 2 and the expected return is 12.5. Clearly, the higher the beta, the expected rate of return is also relatively high. This can explain that the investors will only take the risk when they can earn more.

Applications of the CAPM
There are some advantages of CAPM. First of all, the CAPM is quite simple and clear. Secondly, it widely used because of it is practicable. Investors can evaluate and choose stocks by using CAPM through non-diversification risk rather than the entire risk which is including systematic and unsystematic risk(Arnold, 2013). Thirdly, the CAPM is an instrument for investors to choose the best stock. In addition, it helps to illustrate the positive relationship between risk and return and it is good for identifying mispriced shares and then it is an investor behaviour guideline(Nel,2011).

Estimated the cost of equity
A company needs to calculate the cost of equity first in order to estimate the weighted-average cost of capital(WACC). According to Brealey, Myers and Allen(2011), most generous financial companies calculate the cost of equity by using the CAPM. It is the formula which is use for calculating the weighted average cost of …show more content…

In other words, the expected return of A is higher than the required return at the same risk level. In addition, this portfolio A is underpricing and it is worth to buy. Portfolio B is overpricing and it needs to sell. It is because at the same beta coefficient the expected return is lower than the SML. If investors can get a higher return for the same risk level and they will not choose the lower one. To conclude, investors can use CAPM and SML to identify the share price and choose whether sell it or not.

Limitations of the CAPM and Three factor model
Although CAPM is widely used in asset pricing, there are some limitations of the CAPM. Firstly, the CAPM only think about beta and ignore some risk factors. Secondly, the ideal assumption is hard to achieve. In other words, the market is not perfect which cannot fulfill all the basic premise of the CAPM. Thirdly, it is not easy to estimate the beta coefficient. In addition, beta is estimated by historic data which may change in the future, investors only care about the future price variability so the beta sometimes can be regarded as

Show More
Related

  • Risks Facing Investors in the Article, Can We Keep Our Promises?” by Robert D. Arnott

    1677 Words  | 4 Pages

    By focusing on only one risk, for example peer risk, it leaves the company up for even more risk in its assets and pension obligations. Figure 1 illustrates that these risks do indeed rely on one another. When investors try to only minimize one of the risks (small circles) stockholders leave themselves open / exposed to the other two scopes of risk: Beta and Matching (ALM).

    Read More

  • JB HI-FI Case Study

    766 Words  | 2 Pages

    The estimates of cost of capital for equity 6.14% are making by using the capital asset pricing model (CAPM) to generate forecast of DDM and RIM. This method is defined by the sum of risk free rate plus beta that multiplied with a risk premium. Particularly, the beta, which is a quantitative measure of the volatility of company stock relative to the unstable of the overall market, found in JB HI-FI case at 0.56 (JB HI-FI financial statement 2016). It

    Read More

  • Dimensional Fund Advisors

    1217 Words  | 3 Pages

    Fama and French findings shocked the modern portfolio theory and their study was nick named "Beta is Dead". With respect to CAPM they found that stocks with high betas did not have consistently higher returns than low-beta stocks. Furthermore, Fama and French concluded that a high book value to market value was the most important variable related to predicting high stock returns on small cap stocks. These findings were published in a 1992 paper titled "The Cross-Section of Expected Stock Returns".

    Read More

  • Practice of the Initial Public Offering IPO in the UK

    1148 Words  | 3 Pages

    S/F/36. IPO valuation and analysis This work presents classical analysis of the Initial Public Offering (IPO). First of all, the general financial position of the company and the quality of management are scrutinized. This is an important step in the analysis as it allows approaching the valuation step with all necessary adjustments made beforehand. Then the valuation process itself is conducted. The author uses post-IPO cash-flow analysis in order to allow for substantial reduction of debt due to the IPO. CAPM and WACC concepts are utilized to obtain the value of the company. However, this work is not only useful for IPO valuation. The author makes comprehensive analysis of benefits and disadvantages of the IPO. The role of the underwriter and qualities it has to possess are also discussed. Since there may exist the phenomenon of short-run overperformance and long-run underperformance, the analysis of stock market returns is accomplished. Finally, the appropriateness of different stock exchanges for different types of company is discussed. The paper will be useful for students doing comprehensive case-study of the IPO.

    Read More

  • Proindex Fund Case Study

    2343 Words  | 5 Pages

    Over the previous five years, the return of the ProIndex fund have outperformed the S&P 500 index, as the 5-year-return is nearly 3 times than the benchmark and the annualised return is nearly 2 times than the benchmark. It means ProIndex fund has a significant increase in value within that period. However, the ProIndex Fund has a higher standard deviation which means it is more risk than the S&P 500 index. Especially for the annualised standard deviation, it is approximately 10% higher than the benchmark. The correlation coefficient between the ProIndex and benchmark is about 0.65 which means both two variables are positive changing consistently, but there are still some other factors which have impacts on the relationship between two variables as the correlation is less than 1. Furthermore, the higher beta, 1.0132, which is more than 1 and it may be one of the reasons for high risk as well since it is more sensitive to the market change. It means that the ProIndex fund would increase by 1.0132% if the market increased by 1%.

    Read More

  • Finance Q & A

    959 Words  | 2 Pages

    Primarily, financial managers look at the market price in maximizing the value of the firm. The market value is the present value of the net cash flow divided buy the risk. Investors consider the firm’s future and present earnings, disadvantages or risks and other factors that will influence a firm prior to deciding to create an investment decision and the market price of the stock that will reflect all the information considering these factors (Arain, 2011).

    Read More

  • Firm-Specific Risk: An Analysis Of Firm-Specific Risk

    899 Words  | 2 Pages

    Market Risk is also known as Systematic Risk due to its broad impact on investments. The level of Market Risk depends on the probability that the entire market will decline and drag down the values of all companies. With Market Risk, investors stand to lose value irrespective of the companies, business sectors, or investment vehicles they are invested in. It can be difficult for investors to protect themselves against market risk, since investment strategies, like diversification, is mostly ineffective (Investopedia,

    Read More

  • Portfolio Analysis and Investment

    987 Words  | 2 Pages

    Investment theory is based upon some simple concepts. Investors should want to maximize their return while minimizing their risk at the same time. In order to accomplish this goal investors should diversify their portfolios based upon expected returns and standard deviations of individual securities. Investment theory assumes that investors are risk averse, which means that they will choose a portfolio with a smaller standard deviation. (Alexander, Sharpe, and Bailey, 1998). It is also assumed that wealth has marginal utility, which basically means that a dollar potentially lost has more perceived value than a dollar potentially gained. An indifference curve is a term that represents a combination of risk and expected return that has an equal amount of utility to an investor. A two dimensional figure that provides us with return measurements on the vertical axis and risk measurements (std. deviation) on the horizontal axis will show indifference curves starting at a point and moving higher up the vertical axis the further along the horizontal axis it moves. Therefore a risk averse investor will choose an indifference curve that lies the furthest to the northwest because this would r...

    Read More

  • Essay On Capital Asset Pricing Model

    1344 Words  | 3 Pages

    Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).

    Read More

  • The work of Darwin

    1227 Words  | 3 Pages

    Fama, E.F. and French, K.R. (2004). The Capital Asset Pricing Model: Theory and Evidence. The Journal of Economic Perspectives, 18, 3, 25-46. Retrieved December 2nd, 2011 from jstor.org

    Read More

  • The Importance of Proper Asset Allocation

    1614 Words  | 4 Pages

    According to Investopedia (Asset Allocation Definition, 2013), asset allocation is an investment strategy that aims to balance risk and reward by distributing a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. There are three main asset classes: equities, fixed-income, cash and cash equivalents; but they all have different levels of risk and return. A prudent investor should be careful in allocating each asset class to his portfolio. Proper asset allocation is a highly debatable subject and is not designed equally for everybody, but is rather based on the desires and needs of the individual investor. This paper discusses the importance of asset allocation, the differences and the proper diversification within the portfolio.

    Read More

  • Stock Investment Research Paper

    808 Words  | 2 Pages

    People are investing money every day, and the result of investing is a flow of money through their entire life. Investing money requires educated thinking, and can be a way to make money very easily. There is a risk factor of losing your money when you invest in a company, some more than others. Two of the most common investing methods are stocks and bonds. Stocks, also known as shares, are units of equities in a company.

    Read More

  • Strong Economy and Its Effect on Financial Market

    902 Words  | 2 Pages

    Following the trend of economy, it is important to investors to understand that strong economy creates strong stock market. To elaborate further, as stock prices are increased by current and future expectations of earnings, thus without a strong economy it would be difficult for the companies to increase and sustain their earnings (Kong 2013). The economy development is usually calculated using the gross domestic product of a countries. On the other hand, a change is the stock price can also cause a major impact to the consumers and investors directly. Hence, a loss in confidence by investors can cause a downturn in consumer spending in the long term, which will also affect the economy’s output (Aysen 2011). The graph below shows the relationship of stock market price (KLCI) and the GDP of Malaysia in 2009. Thus, it can be concluded that the economy and the stock market has a positive relationship.

    Read More

  • Short Term And Long Term Capital

    839 Words  | 2 Pages

    Short term and long capital are needed for organizations to survive in today's economy. Organization's now more that ever need these different sources to diversify, expand or to keep processes more efficient thus keeping them at the head of the pack. Today's businesses and consumers demand for speed and quality of products.

    Read More

  • Financial Theories And Strategies

    1533 Words  | 4 Pages

    The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.

    Read More

More about Capital Asset Pricing Model Essay

Open Document