CAPM

The use of Beta and CAPM by a Fund Manager



The use of Beta and CAPM by a Fund Manager

Capital Asset Pricing Model

The CAPM is a financing model used to assess the value of market portfolios by examining the relating systemic risk and the expected return. In actuality, the theory divides risk into two categories of risk, systemic and specific. Although, the CAPM only compensates investors for the systemic risk of the holding a portfolio since specific risk can be diversified. Risk in the CAPM is assumed as wanting to be avoided, but if the 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.

It should be noted, however, that the CAPM 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 CAPM is a one period model. It also generalizes all investors as having the same belief in returns, they receive all costless information simultaneously, and there is a frictionless, perfectly competitive market. Next, it assumes there are risk-free assets that are without restraint and at a constant rate (Reilly & Brown, 2003, 133). It also does not take into account human capital, taxation, regulations, or restrictions on short selling. Incidentally, even though these assumptions and others are not usually met in reality, the CAPM still remains as one of the most widely used tools for determining expected return and risk when investing in market portfolios.

The CAPM is used to determine the expected rate of return of an asset. At equilibrium, if added to a well diversified investment portfolio will be able to fall anywhere along the red line, known as the Capital Market Line. As in the Markowitz model, as the investor is at greater risk (rightward shift) gets a higher expected return (Atrill, 1997, 65-69). 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.

E (Ri) = Rf + ßi (E(Rm) - Rf)

Where,

E (ri) is the expected rate of return of capital on the asset i.

ßim is the Beta (amount of risk with respect to the Market Portfolio)

E (rm - rf) is the excess return of the market portfolio.

(rm) Performance of the market.

(rf) Return on risk free asset.

Assumptions in Capital Asset Pricing Model

The assumptions used in the Capital Asset Pricing Model (CAPM) are similar in that they assume an almost “perfect world” scenario. Initially, CAPM assumes, that all investors have the same rational expectations of returns, and that these returns are in line with the best prediction for future returns as based on the available information. It also makes the assumption that the dividends are paid normally that assets ...