FINANCE

Capital Asset Pricing Model

Capital Asset Pricing Model

Introduction

The study is related to the Capital Asset Pricing Model, the CAPM is a financing model used to evaluate 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 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.

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 also generalizes all investors as having the same belief on 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. 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 capital asset pricing model still remains as one of the most widely used tools for determining expected return and risk when investing in market portfolios.

Fundamental Features of the Capital Asset Pricing Model

Financial managers 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. CAPM provides information, such as;

1. Estimation of the investment's after tax cash flow.

2. Prediction of the investment's risk.

3. Estimation of the cost of capital (the expected rate of return demanded by investors for equivalent risk assets).

4. Calculation of the net present value of the investment by discounting the cash flows using the cost of capital.

Financial managers that 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.

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 ...