FINANCE THEORY

Role of CAPM in modern asset pricing literature



Role of CAPM in modern asset pricing literature

Introduction

CAPM (Capital Asset pricing model) was formulated by (William Sharp and John Lintner) in 1965. this model is considered as the reformulation of asset pricing theory as it provide financial analyst a platform of analyzing the risk and return of investment made by the companies, or of stock exchange of the company. William Sharp in 1990 was awarded noble prize for his tremendous efforts in the field of finance (Fama & French 2004). CAPM model was introduce almost four decades and is still being considered as an appropriate financial tool by majority of the companies for calculation of firms cost of capital, and evaluating the overall performance of the selected portfolio of the firm.

The most amazing quality of the capital asset pricing model is that is provide companies almost accurate and instinctively satisfying predictions regarding how company will measure the risk and relation the occur between expected return and risk of the investment or portfolio. However, besides its current usage the empirical analysis of CAPM shows negative report that is sufficient enough to overthrow the manner it is being used in application of the organizations (Lackman, 2006). Negative empirical results of CAPM most probably reflect lack of qualitative literature on this model that ultimately has a negative impact on authentic implementation for the project for instance. hence, in order to analyze the role of CAPM in modern assets pricing literature it is imperative to deeply understand the function of CAPM and its role played in analyzing the risk of the portfolio and investment (Bali & Engle, 2010).

Discussion

to improve the overall ratio of portfolio the capital asset pricing model can be implemented in simple and perceptive manner. Affective implementation of CAPM can be done using four common assumptions firstly, investors are generally considered to reluctant in investing in risky assets and normally asses the profitability of their investment by calculating their future return and risk for overall period of investment (Levy, 2010). Secondly, capital markets are considered to be ideal under numerous factors like, all the available assets in the market are substantially detachable, transaction cost of the assets are either minimal or zero, there is limitation of taxed and constraint in short selling of the assets. In addition, information regarding the assets is authentic, costless, and must be provided to each individual investors of the market.

Thirdly, all investors must be allowed equal opportunity to participate in the same investment, fourthly, generally similar estimation regarding the investment is observed from all the participating investors. Above defined assumption normally describes the simple world but it is essential to use essential model of CAPM under all these assumptions. In order to reduce the increasing complexities of CAPM it has been reformulated number of times by financial experts using modern resources and techniques. However, under the above-defined assumption, and according to the prevailing prices of the assets in the market investors will generally aim to speculate maximum return ...