Corporate Finance



Capital Asset Pricing Model

Introduction

The most important question that arises when making an investment how the risk impact on the expected returns of investment. The answer has been provided by the CAPM i.e. Capital Asset Pricing Model. CAPM is a frame work which provides a relationship between the risk and expected return.

Discussion

CAPM equation and its components

CAPM is model for pricing individual securities or portfolio securities. The component of CAPM are Risk free rate i.e. Rf, market return i.e. Rm and Beta. The capital asset pricing model is a powerful tool for corporate capital budgeting and performance measurement. The CAPM takes into account the sensitivity of the asset at risk non-diversifiable, known as market risk or systematic risk, represented by the symbol of Beta (ß), as well as expected market return and the expected return of an asset theoretically risk-free.

A key variable used in determining asset price in the CAPM model is the return on the market. This variable is essential because any change in the market return has a significant impact on the return expected by an investor. However, the value that is used is a substitute or proxy for the total market valuation a market index such as the S&P 500 (Izhakian Y., 2012). Example:

Among three companies, Sony Corporation has the higher cost of equity due to the higher beta. The theory suggests that the larger beta, investors expects higher return.

Total Risk Can Be Diversified

CAPM is a financing model used to evaluate the value of market portfolios by examining the relating systemic risk and the expected return. Basically, the theory divides risk into two categories of risk, systemic and specific. Although, the capital asset pricing model only reimburses investors for the systemic risk of the holding a portfolio since specific risk can be diversified away. Risk in the capital asset pricing model is assumed as wanting to be avoided but if risk is accepted then investors expect to be rewarded, called risk premium. In addition to the risk premium paid to the investor, he or she will also be rewarded the risk free return rate (Jagannathan, Ravi & McGrattan, 1995).

It should be noted, however, that the capital asset pricing model is valid under certain assumptions. First, as mentioned previously, this model assumes that investors are risk avoiders who want to maximize their wealth within the period. Specifically, the capital asset pricing model is a one period model. It ...