Capital Asset Pricing Model (CAPM)

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The capital asset pricing model (CAPM) is a mathematical model that offers an explanation about the relationship between investment risk and return. By dividing the covariance of an asset's return by the variance of the market, an asset value can be determined. To ascertain the risk level of a particular asset, the market is evaluated as a whole. Unlike the DCF model, the time value of money is not considered. This model assumes the investors understands the risk involved and trades without cost. Two types of risk is associated with the CAPM model: unsystematic and systematic. Unsystematic risks are company-specific risk. For example, the value of an asset can increase or decrease by changes in upper management or bad publicity. To prevent total loss, the model suggests diversification. Systematic risk is due to general economic uncertainty. The marketplace compensates investors for taking systematic risk but not for taking specific risk. This is because specific risk can be diversified away. Systematic risk can be measured using beta. For example, suppose a stock has a beta of 0.8. The market has an expected annual return of 0.12 and the risk-free rate is .02 Then the stock has an expected one-year return of 0.10.

E( ) = .02 +.8[.12 – .02] = 0.10

According to CAPM, the value of an asset fluctuates because of unpredictable economic shifts. The basis for CAPM is that asset risk is measured by the variance of its return over future periods. (McCullough, 2005) Assets with β < I will display average movements in return less extreme than the overall market, while those with a > I will show return fluctuations greater than the overall market. All other measures of risk is not important. CAMP works best for long-term investments.

Ki = the required return on asset i

Rf = risk-free rate of return on a U.S. Treasury bill

βi = beta coefficient or index of non-diversifiable risk for asset i

km = the return on the market portfolio of assets

The Discounted Cash Flow Method, (DCF) summarizes a company cash flow to reflect the time value of money. It can be used to evaluate or compare investments or purchases. Unlike CAPM, DCF uses the present value concept. It puts forth the idea that money invested today should be worth more than money received in the future. Thus, the value of money received in the future is discounted to reflect its lesser value.

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