CAPM

Capital Asset Pricing Model: Relationship of Returns on Security and its Risk

Capital Asset Pricing Model: Relationship of Returns on Security and its Risk

Introduction

For an investor, capital asset pricing model play crucial part in managing risk of the portfolio. Capital Asset Pricing Model is a model for estimating the alternative cost of capital which is the model used throughout the world, to estimate the cost of capital, or put another way, the return to be obtained by shareholders of a company to invest your money in it. However, the CAPM has been called into question many times, and especially, empirical evidence shows that is not working properly to estimate the cost of capital in the markets emerging.

Discussion

Fundamental Features of the CAPM

CAPM calculates the appropriate rate of return required to discount future cash flows that will produce an asset, given the risk assessment is that asset. Betas greater than 1 symbolize that the asset has a higher than average risk of the entire market betas below 1 indicate a lower risk. Therefore, an asset with a high beta should be discounted at a higher rate as a means to reward the investor for taking the risk that the asset carries. This is based on the principle that investors from riskier investments require higher returns.

The capital asset pricing model is a model often used in financial economics. The model is used to determine theoretically the rate of return required for a particular asset if it is added to an investment portfolio well diversified. The model takes into account the sensitivity of the asset at risk non-diversifiable also 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 a theoretically risk free asset (William, 2008, 425-442). CAPM is useful for the financial managers as they can use capital asset pricing model for making a number of decisions concerning financial dispositions. Perhaps the most common corporate financial decision is the valuation of a capital investment opportunity. Capital asset pricing model provides information that includes estimation of the investment's after tax cash flow, prediction of the investment's risk, estimation of the cost of capital (the expected rate of return demanded by investors for equivalent risk assets (Arnold, 2005, 872 -905). In addition to this, calculation of the net present value of the investment by discounting the cash flows using the cost of capital; moreover, financial managers who are equipped with this information can make financial decisions. The capital asset pricing model is a powerful tool for corporate capital budgeting and performance measurement.

Assumptions of CAPM

The assumptions of the capital asset pricing model include that the investors are well diversified, and therefore is relevant only systematic risk (risk that affects all shares of the market, to a greater or lesser degree, but all of them. Examples of systematic risk are devaluations, recessions, increases in the rates of interest etc. The specific risk of each title or unsystematic risk is eliminated through diversification and therefore is ...