The Capital Asset Pricing Model

CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.

‘The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the industry even though it is based on very strong assumptions. Discuss in the light of recent developments in the area.’

The capital asset pricing model can be used to calculate the firm's cost of capital, or at least the firm's cost of equity. The cost of equity reflects the firm's cost of using equity capital to finance its operations. The use of CAPM is effective, because the beta is based on market performance of the company's stock. The market is assumed to be capable of making an accurate

In order to test the validity of the CAPM, we have applied the two-step testing procedure for asset pricing model as proposed by Fama and Macbeth (1973) in their seminal paper.

Even though there are flaws in the CAPM for empirical study, the approach of the linearity of expected return and risk is readily relevant. As Fama & French (2004:20) stated “… Markowitz’s portfolio model … is nevertheless a theoretical tour de force.” It could be seen that the study of this paper may possibly justify Fama & French’s study that stated the CAPM is insufficient in interpreting the expected return with respect to risk. This is due to the failure of considering the other market factors that would affect the stock price.

Eugene Fama from the University of Chicago and Kenneth R. French from the Yale School of Management's were done a research on examining the validity of capital asset pricing model (CAPM). It was published in 1992; and well-known as The Fama-French three factors model (TFM).

The expected return for each of the stocks has been calculated by the Capital Asset Pricing Model. The risk free rate is one of the variables used in the CAPM formula. The risk free rate has been assumed here at 7% based on historical statistics as no information has been given regarding it. The second variable is the return on market. This return has been estimated from the average monthly return by transforming it into effective expected annual rate of return. Finally, the third variable used in the CAPM formula is beta which has been calculated in the third question. This beta incorporates the systematic risk in the formula to calculate the expected return for a particular stock. The expected return for Brown Group is 14.87% and for California RIET it is 8.00%. This shows that the expected return for Brown Group is much higher than the expected return of California RIET.

If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative, the CAPM would

Furthermore, the CAPM is only a single-period model. Critics mention that estimates for the risk-free rate, market return and beta factor, are difficult to accurately determine in real-life. The assumption that diversifiable risk is not taken in consideration does not work well for investors that do not have a well-diversified portfolio. CAPM therefore overlooks unsystematic risk, which may be of importance to investors who do not have a diversified portfolio. The CAPM’s validity is due to difficulties in applying valid tests of the model. CAPM states that “the risk of a stock should be measured relative to a comprehensive “market portfolio” that in principle can include not just traded financial assets, but also consumer durables, real estate and human capital” (Hill, 2014). Even though CAPM is widely used in the corporate world, according to Fama and French (2004), CAPM has never been an empirical success (p.43). Researchers found variables like size, various price ratios and momentum that affects the average returns provided by beta (Fame and French, 2004, p.43). The issues addressed in the studies were serious enough to invalidate most applications of the CAPM (Fama and French, 2004, p.43). According to Wu (2007), the only economic prediction of CAPM is that the market portfolio is mean-variance efficient. In study cited by Wu (2007), Roll argues that a “true market portfolio should include all

In order to maximize a portfolio’s return, it is important to analyze risk and diversify securities, while adhering to the goals of an investor. Through analyzing the different classes of risk, one can match investments to an investor’s risk tolerance and return requirements. Even though some investments may present greater risk they are countered by a higher rate of return and vice versa, less risk corresponds to a lower return. Moreover, investment risk can be substantially reduced through diversification, which spreads a portfolio across different industries, businesses and investment options. The makeup of a diversified portfolio continually changes based on an investor’s time horizon and investment goals. In accordance with the Modern Portfolio Theory (MPT), one can maximize return while reducing risk, through assessing investments standard deviation and beta. When applied to the capital asset pricing model (CAPM) an investor can determine what the expected rate of return should be and if the risk is worth it. Therefore, by analyzing risk and diversifying investments one can maximize an investment growth, increasing a portfolios return.

There are many different asset pricing and portfolio management models available to assist us in the estimation and evaluation of a stock’s return. The Fama-French Model (“FFM”) is one of those models. Kenneth French and Eugene Fama who were professors at the University of Chicago Booth School of Business designed the FFM. Kenneth French and Eugene Fama observed that historically, the Capital Asset Pricing Model (“CAPM”), which was predominantly used, was inaccurate as it often resulted in high alpha values which meant that a huge portion of excess returns were left unexplained. They also observed that companies with smaller market caps would outperform companies with higher market caps and companies with higher book-to-market (“B/E”)

Critical Analysis of the Relative Merits of the Capital Asset Pricing Model (CAPM) and the Fama and French (F&F) Three-Factor Model (TFM)

Empirical evidence in the early years of CAPM provided support especially with Sharpe and Copper

Richard Roll, and University and Auburn, University of Washington, and University of Chicago educated economist, began his career researching the effect of major events of stock prices. This experience likely helped him reach the two conclusions he makes in his 1977 “A Critique Of The Asset Pricing Theory’s Tests”, one of the earliest and most influential arguments against CAPM. In the paper, Roll makes two major claims: that CAPM is actually a redundant equation that just further proves the concept of mean-variance efficiency, and that it is impossible to conclusively prove CAPM. His first claim relates to mean-variance efficiency: the idea that mathematically one must be able to create a portfolio that offers the most return for a given amount of risk. Roll claims that all CAPM is doing is testing a portfolio’s mean variance efficiency, and not actually modeling out projected future returns. The second claim in the paper is that there is not enough data about market returns for CAPM to ever prove conclusive. Even if modern technologies could help alleviate some of the burden of testing market returns for publicly traded equities, there is still no way to account for the returns of less liquid markets, where there is less public information. This means it is impossible for

The main objective of doing this project is to develop students understanding about Malaysia Capital Market. Malaysia Capital Market involve of shares and investment. This project also study the relationship between expected return, standard deviation, coefficient of variation, covariance, correlation, beta and capital asset pricing model.