Capital Asset Pricing Model Essay Example for Free

Capital plus Pricing Model analyseThe capital asset pricing model (CAPM) is an important model in finance speculation. CAPM is a theory or model use to calculate the risk and judge establish direct of an investment portfolio (normally link to stocks or dowrys). All stocks consume 2 risks Systematic jeopardy (also called Market Risk which affect each stocks) and Untaxonomic Risk (also called Specific or Unique Risk that only affects individual stocks). To diversify disorganized risk, we selected and combined different stocks, which are negatively correlated with unity a nonher into one portfolio. In this centering 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 return rate of the investment portfolio rf = Risk free rate of return = Beta (correlation between the shares and the grocery store) rm = Expected market return whi ch also means rm rf = Market risk (systematic risk) (rm rf) = Risk premium *Beta is general risk value for investing in the stock market. The higher the important, the more the risk.CAPM Example Assume thither is two Investment portfolio (stocks) or project A B. With the information given below, we can use CAPM to help us decide which to invest on. risk free rate beta evaluate 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 all overall market and B is 1.5 times less risky. Expected return scram 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 %victimization 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 i s definitely a better but if you dont have 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 determine the expected return of a investment portfolio, It still have its limitation. Many had criticized on its unrealistic assumptions. Required 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. Therefore unsystematic risk is ignore in CAPM calculation. Beta as it main(prenominal) calculation componentsAs Beta value are computed base on past one grade figures so in this case CAPM assume that the future wont change. Also beta may not really reflect the actual performance of different stocks. This was question by professors Eugene Fama and Kenneth Fr ench where they looked at share returns on the New York Stock 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 latch on or lend at this rate but it is not true in the real world. thoroughgoing(a) capital market exists There is no transaction cost for trading in the market and advance is non-taxable. All investor are the same CAPM assume all investors have the same expectations on the risk and expected return.