The Capital Asset Pricing Model Essay

Given these approximations, the CAPM model would total the risk-free rate and the market risk premium times beta to arrive at a cost of equity of 9.68%, which reflects the investors’ expected return from investing in shares of the company.

CAPM is a model that describes the relationship between risk and expected return, and the formula itself measures the expected return of the portfolio. Mathematically, when beta is higher, meaning the portfolio has more systematic risk (in comparison to the market portfolio), the formula yields a higher expected return for the portfolio (since it is multiplied by the risk premium and is added to the risk free interest rate). This makes sense because the portfolio needs to

The CAPM is a single factor model because it based on the hypothesis that required rate of return can be predicted using one factor that being systematic risk. It looks at risk and rates of returns, compares then to the stock market providing a usable measure of risk to help investors determine what return they will get for risking their money in an investment. There are a lot of assumptions and drawbacks of CAPM that lead to the conclusion that those investors utilizing this

Risk free rate + Equity Beta * (Expected return on market - Risk free rate)

Utilizing the fundamental concepts of the Capital Asset Pricing Model (CAPM), the expected return for Wal-Mart stock is 7.01% [E(R)]. This is a result of a risk-free rate (Rf) of 3.68%, which was the provided 10-year government bond yield to use as a proxy for the risk-free rate. The beta (β ) of Wal-Mart was 0.66 according to the provided Bloomberg beta estimate. Additional data was provided on the U.S. market risk premium [E(RM) – Rf] of 5.05%. In following the general concepts of CAPM, there are some general assumptions: no transaction costs, all assets are publicly traded,

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.

Please refer to Appendix 2 for other considerations for cost of equity calculations. Most firms use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. The components that make up the CAPM include: the risk free rate, the beta of the security, and the expected market return of the stock. These values are all based on forward-looking data. The model dictates that shareholders require a return equal to the return from a risk-free investment plus an equity risk premium for bearing extra risk. Refer to Appendix 1 for a full breakdown of the CAPM formula.

This essay will highlight the use of Capital asset pricing model ( CAPM ) to be considered as a pricing theory model for assets . CAPM model helps investors to analyse the risk and what expectation to keep from an investment (Banz , 1981) . There are two types of risk

CAPM on the other hand is based on microeconomic ideas such as concave utilities and costless diversification. Macroeconomic events mentioned include interest rates or the cost of labor, causes the systematic risk that affects the returns of all stocks. On the other hand the firm-specific events are the unexpected microeconomic events that affect the returns of specific firms for example the death of key people that would affects the firm, but would have a insignificant effect on the

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.

However, the R Square of this regression is 0.5939 that means only about 59% variable can be explained by this regression. This result show that the CAPM model lacks some factors or information to explain these variable.

As indicated by the case study S&P 500 index was use as a measure of the total return for the stock market. Our standard deviation of the total return was used as a one measure of the risk of an individual stock. Also betas for individual stocks are determined by simple linear regression. The variables were: total return for the stock as the dependent variable and independent variable is the total return for the stock. Since the descriptive statistics were a lot, only the necessary data was selected (below table.)

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.

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

We use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. As