CAPM ANALYSIS

Understanding the Concept of Capital Asset Pricing Model



Introduction4

Discussion4

1. The Historical background of the Capital Asset Pricing Model4

2. What CAPM Stands for5

2.1. CAPM in 21st Century7

3. Beta & Its Uses8

4. Strengths Relating To CAPM and Beta8

5. Weaknesses Relating To CAPM and Beta9

6. Statistical Analysis9

6.1. Interpretation of Graphical Outcomes Regarding the provided Beta9

7. Conclusion10

References11

Appendix12

Understanding the Concept of Capital Asset Pricing Model

Introduction

Financial models are developed and designed to investigate the economic and financial side of a business and its operations. However, literature elucidates various perspectives with respect to the effectives and applicability of these models. Among those so many models CAPM is considered as most important. The reason behind its importance is its applicability on almost every kind of business model.

The report is written with an aim to identify and investigate about the fundamental features of the Capital Asset Pricing Model, the model's essentiality and the validity in the current era of uncertainty and the conclusion encapsulating the final words on the aforementioned broad tenets. I am going to follow given below outline to elucidate the concept of CAPM and Beta

Historical Background of CAPM

Overview of CAPM

Beta & its Uses

Strengths of CAPM & Beta

Weakness of CAPM & Beta

Statistical Analysis

Conclusion

Discussion

1. The Historical background of the Capital Asset Pricing Model

CAPM is a very renowned name in the field of finance and financial economics; it was introduced by Jan Mossin, John Linter, William Sharpe, Jack, Treynor in1966, 1965, 1964 and 1962 respectively. The CAPM is actually a risk and revenue model and used to calculate expected returns for a company.

1.1. CAPMAssumption

The model is more advanced and complicated but there is a more simplified model which has to undergo several assumptions to be useful, those are as follows;

“All investors have a wealth that is smaller to the total wealth of all investors. The perfect competition assumption”

Investors like short term investments

Investments “are limited to a universe of publicity traded financial assets, such as stocks and bonds, and to risk-free borrowing or lending arrangements”. “Investors do not need to pay any taxes on returns nor transactions cost on trades in securities”

All investors are “rational mean variance optimizers”

All investors “analyze securities in the same way and share the same economic view of the world”. Resulting in identical estimations of future cash flows from their investments. (Advani 2006 45-49)

2. What CAPM Stands for

CAPM is the best model for estimating the required rate of return for SLP Company. It has been tried and tested now for more than 40 years. It has been tested rigorously through empirical research and it has withstood the time. It considers the systemic risk for a diversified portfolio of securities and incorporates reality. CAPM incorporates risk well by taking beta into account and gives investor two benefits in the form of time value of money and risk taking benefits. Other model such as dividend discount model has its shortcoming when it comes to companies that are not paying dividends; in that case the cost of ...