Capital Asset Pricing Model Essay

The capital asset pricing copy (CAPM) is an important model in finance theory. CAPM is a theory or model use to visualize the encounter and expected fall out account of an investment portfolio (normally refer to stocks or shares). All stocks have 2 essays Systematic Risk ( in any case called Market Risk which affect every stocks) and Unsystematic Risk (also called Specific or Unique Risk that only affects individual stocks). To diversify irregular risk, we selected and combined different stocks, which are negatively correlated with one a nonher into one portfolio. In this way risk are eliminated greatly. See diagram below.CAPM Equation The general formula used for Capital Asset Pricing Model is re = rf + (rm rf) where the components are as follows re = Expected guide rate of the investment portfolio rf = Risk leave office rate of return = Beta (correlation between the shares and the market) rm = Expected market return which also means rm rf = Market risk (systematic r isk) (rm rf) = Risk premium *Beta is overall risk shelter for investing in the stock market. The higher the beta, the more the risk.CAPM Example Assume there is two Investment portfolio (stocks) or bedevil A & B. With the information given below, we can use CAPM to help us decide which to invest on. risk free rate beta expected market return A 3% 2.5 10% B 3% 1.2 10%From the beta value above, we know A is a more risky portfolio. A is 2.5 times more risky than the overall market and B is 1.5 times less risky. Expected return earn by A re = rf + (rm rf) re = 3 + 2.5 (10 3) = 20.5 % Expected return produce by B re = rf + (rm rf) = 3 + 1.2 (10 3) = 11.4 %Using CAPM formula, we calculated A produce a 20.5% expected return rate. It is higher than the overall market expected return, which is 10%. Whereas for B, the expected return rate are only 11.2% compare to market return of 10%. Base on result, A is definitely a better solely if you dont feel conformable with As risk or think it might not able to produce the expected return rate, then you would probably can choose investing in B.Criticisms of CAPM Although CAPM seems to be one of the most widely used methods to find oneself the expected return of a investment portfolio, It still have its limitation. Many had criticized on its unrealistic assumptions. indispensable a well-diversified portfolioFirstly CAPM works really well with a well-diversified portfolio as it accounted for systematic risk (market risk) but as seen on the graph on page 1, systematic risk is still undiversified. in that locationfore unsystematic risk is ignore in CAPM calculation. Beta as it main calculation componentsAs Beta value are computed base on past one year figures so in this case CAPM walk out that the future wont change. Also beta may not really reflect the certain performance of different stocks. This was question by professors Eugene Fama and Kenneth French where they looked at share returns on the New York pedigree Exchange, the American Stock Exchange and Nasdaq between 1963 and 1990, they found that differences in betas over that lengthy period did not explain the performance of different stocks. The linear relationship between beta and individual stock returns also breaks down over shorter periods of time. These findings seem to suggest that CAPM may be wrong. Risk free rate of returnCAPM assumes there is a risk free rate where investors can borrow or lend at this rate but it is not true in the real world. Perfect capital market exists There is no transaction cost for trading in the market and profit is non-taxable. All investor are the resembling CAPM assume all investors have the same expectations on the risk and expected return.