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The Capital Assets Pricing Model

Introduction

The Capital Assets Pricing Model (CAPM) , is a method of pricing assets of capital nature. This model applies Beta (non-diversifiable risk) to link risks and returns of investments. According to Stahl (2016), Beta is a standard for measuring the systematic risk or the non-diversifiable risk. The uncertainty in the economy of a particular country causes the systematic risk. Systematic risk is that risk sharing or risk diversification cannot reduce. Economic downturns, war, natural calamities and a change of government policy are some of the activities that cause systematic risk. Both CAPM and Beta are measures of risk (Anon 2014). The capital assets pricing model defines the required rate of return of security. CAPM can be a mathematical equation, or a graphical representation is known as the security market line (SML) (Stahl 2015). An analysis of CAPM indicates that there are several critiques of this model. Nevertheless, there are multivariate models used to overcome these critiques.

A).Formulas to Calculate CAPM and Beta

1). Capital Assets Pricing Model

CAPM= [pic]= [pic]+ [pic] (RM-RF)

Where; [pic] is the cutoff rate or even minimum required rate of return

RM- RF is the risk premium and is above free rate RM is the market returns [pic] is the risk-free rate of returns [pic] is the beta of asset j

Illustration

Assuming that [pic]= 1.2, RM= 12% and [pic]= 4%. Use the CAPM to calculate the required rate of return.

Solution

CAPM= [pic]= [pic]+ [pic] (RM-RF)

[pic]= 4+1.2 (12-4)

[pic]= 4+ (1.2 x 8)

[pic]= 4 + 9.6

[pic]= 13.6 %

2). Beta

[pic]= [pic]

Where; [pic] is the covariance between the market and asset j.…...

...page 50 student accountant JUNe/JULY 2008 CAPM: THEORY, ADVANTAGES, AND DISADVANTAGES THE CAPITAL ASSET PRICING MODEL RELEVANT TO ACCA QUALIFICATION PAPER F9 Section F of the Study Guide for Paper F9 contains several references to the capital asset pricing model (CAPM). This article is the last in a series of three, and looks at the theory, advantages, and disadvantages of the CAPM. The first article, published in the January 2008 issue of student accountant introduced the CAPM and its components, showed how the model can be used to estimate the cost of equity, and introduced the asset beta formula. The second article, published in the April 2008 issue, looked at applying the CAPM to calculate a project-specific discount rate to use in investment appraisal. CAPM FORMULA The linear relationship between the return required on an investment (whether in stock market securities or in business operations) and its systematic risk is represented by the CAPM formula, which is given in the Paper F9 Formulae Sheet: E(ri) = Rf + βi(E(rm) - Rf) E(ri) = return required on financial asset i Rf = risk-free rate of return βi = beta value for financial asset i E(rm) = average return on the capital market The CAPM is an important area of financial management. In fact, it has even been suggested that finance only became ‘a fully-fledged, scientific discipline’ when William Sharpe published his derivation of the CAPM in 19861. CAPM ASSUMPTIONS The CAPM is often criticised as being......

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...work of Harry Markowitz on diversification and modern portfolio theory. CAPM model states that the price of a stock is tied on two variables: the time value of money and the risk of the stock itself. Hence the time value of money is represented by the risk free rate or rf. the capital asset pricing model is mainly concerned with how the market risk is measured and how it affects expected returns and share prices. The CAPM Theory has the following suggestions. Investors in shares expect a higher return in excess on the risk free rate to compensate them for the systematic risk Investors with unsystematic risk should not require a premium because it has been diversified away by holding a wide portfolio of investment Because market risk varies from companies to companies , investors will require a higher return from companies with higher systematic risk Market risk is the average risk of the market as a whole. Taking all shares on a stock market together, the returns will vary because of systematic risk. The return the fund manager expects from the individual security will be higher or lower than the market return, depending on whether the security’s market risk is greater or less than the market average. A major assumption of CAPM is that there is a linear relationship between the return obtained from an individual security and the average return from all securities in the market. The CAPM makes use of the principle that return on shares in the market as a......

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...Table of Contents 1. Introduction 3 2. CAPM 3 3. Global CAPM 4 4. International CAPM 4 5. Conclusion 5 6. Reference 5 According to the survey conducted among the most successful US enterprises, 73-85% of the respondent claims to use CAPM as their preferred methodology (Desai, 2005), thereby making CAPM most widely used model to estimate cost of equity. CAPM model is used to estimate the expected return on a risky asset by adding to the risk free rate of return a market risk premium. Sharpe and Lintner built CAPM theory on basis of Markowitz theory of mean- variance portfolio model. 1. Assumption of CAPM Markowitz mean- variance analysis refers to the theory of combining risky assets so as to minimize overall risk of the portfolio at desired level of return. The Markowitz theory is based on three assumption i.e. all investors minimize risk for desired level of expected return or demand additional return for additional risk (risk averse), all parameter of individual asset like expected returns, variance and covariance are known thereby all investors have same expectations of all asset parameter and there are no taxes or transaction cost. Sharpe and Lintner add two key assumptions to the Markowitz model to derive CAPM - individual buy and sell decision does not affect asset price (price takers) and investors can borrow and lend unlimitedly at risk free rate. 2. Limitation of CAPM Assumption The assumption that the investor consider only......

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...On the Use of the CAPM in Public Utility Rate Cases: Comment Author(s): Dennis E. Peseau and Thomas M. Zepp Reviewed work(s): Source: Financial Management, Vol. 7, No. 3 (Autumn, 1978), pp. 52-56 Published by: Wiley on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665011 . Accessed: 08/02/2013 07:25 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. . Wiley and Financial Management Association International are collaborating with JSTOR to digitize, preserve and extend access to Financial Management. http://www.jstor.org This content downloaded on Fri, 8 Feb 2013 07:25:31 AM All use subject to JSTOR Terms and Conditions Utility Regulation and the CAPM: A Discussion On the Use of the CAPM Cases: in Comment Public Utility Rate Dennis E. Peseau and Thomas M. Zepp The authors are Senior Economists on the staff of the Oregon Public Utility Commissioner. * In a recent issue of Financial Management,......

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...Copyright c 2005 by Karl Sigman 1 Capital Asset Pricing Model (CAPM) We now assume an idealized framework for an open market place, where all the risky assets refer to (say) all the tradeable stocks available to all. In addition we have a risk-free asset (for borrowing and/or lending in unlimited quantities) with interest rate rf . We assume that all information is available to all such as covariances, variances, mean rates of return of stocks and so on. We also assume that everyone is a risk-averse rational investor who uses the same ﬁnancial engineering mean-variance portfolio theory from Markowitz. A little thought leads us to conclude that since everyone has the same assets to choose from, the same information about them, and the same decision methods, everyone has a portfolio on the same eﬃcient frontier, and hence has a portfolio that is a mixture of the risk-free asset and a unique eﬃcient fund F (of risky assets). In other words, everyone sets up the same optimization problem, does the same calculation, gets the same answer and chooses a portfolio accordingly. This eﬃcient fund used by all is called the market portfolio and is denoted by M . The fact that it is the same for all leads us to conclude that it should be computable without using all the optimization methods from Markowitz: The market has already reached an equilibrium so that the weight for any asset in the market portfolio is given by its capital value (total worth of its shares) divided by the total......

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...Capital Asset Pricing Model and Arbitrage Pricing Theory in the Italian Stock Market: an Empirical Study ARDUINO CAGNETTI∗ ABSTRACT The Italian stock market (ISM) has interesting characteristics. Over 40% of the shares, in a sample of 30 shares, together with the Mibtel market index, are normally distributed. This suggests that the returns distribution of the ISM as a whole may be normal, in contrast to the findings of Mandelbrot (1963) and Fama (1965). Empirical tests in this study suggest that the relationships between β and return in the ISM over the period January 1990 – June 2001 is weak, and the Capital Asset Pricing Model (CAPM) has poor overall explanatory power. The Arbitrage Pricing Theory (APT), which allows multiple sources of systematic risks to be taken into account, performs better than the CAPM, in all the tests considered. Shares and portfolios in the ISM seem to be significantly influenced by a number of systematic forces and their behaviour can be explained only through the combined explanatory power of several factors or macroeconomic variables. Factor analysis replaces the arbitrary and controversial search for factors of the APT by “trial and error” with a real systematic and scientific approach. The behaviour of share prices, and the relationship between risk and return in financial markets, have long been of interest to researchers. In 1905, a young scientist named Albert Einstein, seeking to demonstrate the existence of atoms, developed an......

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...CAPM essay In the second scenario BBBY would use its $400 million in excess cash and borrow the remaining funds until Question 2 a) We will need to calculate the debt-to GDP ratio for each year separately in order to compute the total accumulation. The following equations and variables are used in question a) ∆b=g-t+r-y* b g-t=2 i=3 π=1 r=i-π=3-1=2 y=1 b=0,9 (=90%) Year 1 ∆b=2+2-1* 0,9=2,9 byear 1=90+2,9=92,9 Year 2 ∆b=2+2-1* 0,929=2,929 byear 2=92,9+2,929=95,829 Year 3 ∆b=2+2-1* 0,95829=2,95829 byear 3=95,829+2,95829=98,78729 Year 4 ∆b=2+2-1* 0,9878729=2,9878729 byear 4=98,78729+2,9878729=101,7751629 Year 5 ∆b=2+2-1* 1,017751629=3,017751629 byear 5=101,7751629+3,017751629=104,792914529 Therefore, after 5 years the debt-to-GDP ratio will be equal to 104,8 % (rounded to one decimal) b) The debt is not sustainable. The criteria to test whether debt is sustainable is as follows: ∆b=g-t+r-y* b=0 Plotting in the known variables results in the following: ∆b=2+2-1* b=2+b= 0 Solving for b gives the following: b= -2 Therefore, the initial debt should be -200% (so surplus) in order to maintain a sustainable debt. c) If the nominal interest rate rises to 10%, it would imply that the real interest rate is as follows: r=i-π=10-π Therefore, we know that: ∆b=g-t+r-y* b=2+10-π-1*0,9=2+9-π*0,9 The criteria to maintain a sustainable debt is as follows: ∆b=0 This implies that ∆b= 2+9-π*0,9=0 Solving for inflation results in......

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... Il Capital Asset Pricing Model in Excel di Carmelo Maraschiello (maraschiello@vodafone.it) Si è visto nel capitolo relativo al Capm come le scelte di investimento di un investitore razionale possano essere analizzate attraverso l’approccio media/varianza. In particolare si è visto come tra i diversi mix disponibili di portafogli rischiosi, alcuni sono preferibili in quanto associano ad un rendimento maggiore un rischio minore. Tra questi il portafoglio preferito sulla frontiera è quello di tangenza con la Capital Market Line. Nel foglio excel CAPM[1] vedremo come, a partire dai rendimenti di alcune attività rischiose, sia possibile con excel stimare la matrice di varianza covarianza e costruire la frontiera dei mix di investimenti possibili. Analizzeremo quindi la creazione della CML e della SML. Dati [pic] Nel foglio dati, partendo dalla matrice di rendimenti compresi tra la cella C14 e la cella H73, si stimano varianza, covarianza e rendimento medio relativi. Riguardo ai rendimenti questi sono ottenuti attraverso le differenze prime dei logaritmi dei prezzi (lnP(t)–lnP(t–1)) . Considerando ad esempio i primi rendimenti del titolo a: [pic] In excel la stima della varianza è ottenuta tramite la funzione =VAR.POP(), per la covarianza si utilizza l’omonima funzione =COVARIANZA(). La media è calcolata con la funzione media (=MEDIA() ). Chiaramente calcolando la covarianza tra i rendimenti dello stesso titolo si ottiene lo stesso risultato del comando VAR.POP......

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...CAPM METHOD IN ASSESSING RISK AND RETURN OF SHARES TO DETERMINE INVEST IN SHARE OPTIONS JAKARTA ISLAMIC INDEX PERIOD JANUARY 2004-DECEMBER 2008 STOCK EXCHANGE IN INDONESIA Yesica Yohantin Undergraduate Program, Faculty of Economics Gunadarma University http://www.gunadarma.ac.id Keywords: Risk, Return, Beta, CAPM, Investment, JII Stocks ABSTRACT To form portfolio efficient stock, we shall have knowledge how risk which must be accounted and how big return which can we obtain after accounting the risk. Method Capital Assets Pricing Models (CAPM) applicable to analyze risk and return stock. This research aim to analyze calculation CAPM in value of risk and return and choice invests best at JII stocks. Data which is used to in this research is secondary data in the form of closing price monthly stock (monthly closing price), JII Price Index and interest rate monthly SBI. All data is calculated with CAPM method, tested by hypotheses by using of simple linear regression analysis and is processed by using of SPSS 17. Research sample consists of 9 JII stock entering by continues in stock list JII time line 2004-2008, that is ANTM stock, BUMI, INTP, INCO, KLBF, TBBA, TLKM, UNVR, and UNTR. Node result of research is there 5 aggressive stock that is INCO, TBBA, UNTR, ANTM, BUMI, and INTP ; 6 stock having excess positive return that is ANTM, BUMI, INTP, INCO, TBBA, and UNTR ; and there are 6 stock (almost entirely) which having correlation positive linear and β significant that is...

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...Introduction to Finance Return, Risk, and the Security Market Line COMM 298 Outline 1 Portfolios 2 Portfolio Expected Return 3 Portfolio Variance 4 Systematic Risk, Speciﬁc Risk, and Diversiﬁcation 5 Market Portfolio and Measure of Systematic Risk 6 CAPM: From Risk to Return COMM 298 Return, Risk, and the Security Market Line 1 / 54 Outline 1 Portfolios 2 Portfolio Expected Return 3 Portfolio Variance 4 Systematic Risk, Speciﬁc Risk, and Diversiﬁcation 5 Market Portfolio and Measure of Systematic Risk 6 CAPM: From Risk to Return COMM 298 Return, Risk, and the Security Market Line 1 / 54 Portfolios Investors are risk averse. COMM 298 Return, Risk, and the Security Market Line 2 / 54 Portfolios Investors are risk averse. To reduce risk, it is good idea “not to put all your eggs in one basket”. COMM 298 Return, Risk, and the Security Market Line 2 / 54 Portfolios Investors are risk averse. To reduce risk, it is good idea “not to put all your eggs in one basket”. This is achieved by building a portfolio, which is a collection of assets. COMM 298 Return, Risk, and the Security Market Line 2 / 54 Portfolios Investors are risk averse. To reduce risk, it is good idea “not to put all your eggs in one basket”. This is achieved by building a portfolio, which is a collection of assets. The process is called......

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...Copyright c 2005 by Karl Sigman 1 Capital Asset Pricing Model (CAPM) We now assume an idealized framework for an open market place, where all the risky assets refer to (say) all the tradeable stocks available to all. In addition we have a risk-free asset (for borrowing and/or lending in unlimited quantities) with interest rate rf . We assume that all information is available to all such as covariances, variances, mean rates of return of stocks and so on. We also assume that everyone is a risk-averse rational investor who uses the same ﬁnancial engineering mean-variance portfolio theory from Markowitz. A little thought leads us to conclude that since everyone has the same assets to choose from, the same information about them, and the same decision methods, everyone has a portfolio on the same eﬃcient frontier, and hence has a portfolio that is a mixture of the risk-free asset and a unique eﬃcient fund F (of risky assets). In other words, everyone sets up the same optimization problem, does the same calculation, gets the same answer and chooses a portfolio accordingly. This eﬃcient fund used by all is called the market portfolio and is denoted by M . The fact that it is the same for all leads us to conclude that it should be computable without using all the optimization methods from Markowitz: The market has already reached an equilibrium so that the weight for any asset in the market portfolio is given by its capital value (total worth of its shares)......

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... CAPM Yasmeen Iman Snow Deforest Thompson Gary Oha CAPM Contents Overview of CAPM 1 Advantages and Limitations 3 Breakthroughs and Setbacks 4 Works Cited 6 Overview of CAPM The CAPM was introduced by Jack Treynor , William F. Sharpe , John Lintner and Jan Mossin in 1964, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory (Fama & French, 1982). Sharpe, Markowitz and Merton Miller jointly received the 1990 Nobel Memorial Prize in Economics for this contribution to the field of financial economics. Fischer Black developed another version of CAPM, called Black CAPM or zero-beta CAPM that does not assume the existence of a riskless asset. This version was more robust against empirical testing and was influential in the widespread adoption of the CAPM (Fama & French, 1982). CAPM has become very attractive as a tool that measures risk to possible in relation to expected return, although it is still widely used for estimating the cost of capital for firms and evaluating the performance of managed portfolios. While CAPM is accepted academically, there is empirical evidence suggesting that the model is not as profound as it may have first appeared to be. CAPM’s empirical fallings arise theoretically from many over simplified assumptions made by the model. This has made it difficult to implement valid test for this model (Kristina Zucchi, 2015). For example according to the CAPM model the......

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...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.’ MN 3365 Strategic Finance Table of Contents Introduction Concept of CAPM Assumptions of CAPM . Other Suggested Models Disadvantages of CAPM Advantages of CAPM Problems in applying CAPM Conclusion Bibliography / References INTRODUCTION 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 associated with CAPM known as systematic and unsystematic risk . The systematic risks are market risk which cannot be diversified such as fluctuations in interest rates and recession in the economy .Unsystematic risk are risks associated with an individual stock , it occurs when an investor increases the number of stocks on his portfolio. The unsystematic risk cannot be diversified as it is related an individual stock irrespective to the general market . (Amihud and Lev, 1981). The CAPM was introduced independently by Jack Trenor (1961 , 1962) , Jan Mossin (1996) and William F . Sharpe (1964) , it is basically an uplifment of the existing work of Harry Markowitz on modern portfolio therory as well as diversification which was given a name as CAPM ......

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...Description of CAPM. The Capital Asset Pricing Model CAPM was introduced by Treynor ('61), Sharpe ('64) and Lintner ('65). By introducing the notions of systematic and specific risk, it extended the portfolio theory. In 1990, William Sharpe was Nobel price winner for Economics. "For his contributions to the theory of price formation for financial assets, the so-called Capital Asset Pricing Model (CAPM)." The CAPM model says that the expected return that the investors will demand, is equal to: the rate on a risk-free security plus a risk premium. If the expected return is not equal to or higher than the required return, the investors will refuse to invest and the investment should not be undertaken. CAPM decomposes a portfolio's risk into systematic risk and specific risk. Systematic risk is the risk of holding the market portfolio. When the market moves, each individual asset is more or less affected. To the extent that any asset participates in such general market moves, that asset entails systematic risk. Specific risk is the risk which is unique for an individual asset. It represents the component of an asset's return which is not correlated with general market moves. According to CAPM, the marketplace compensates investors for taking systematic risk but not for taking specific risk. This is because specific risk can be diversified away. When an investor holds the market portfolio, each individual asset in that portfolio entails specific risk. But through......

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...CAPITAL ASSET PRICING MODEL What is CAPM actually? Capital Asset Pricing Model, popularly known as CAPM, is a model that provides a framework to determine the required rate of return in an asset and indicates the relationship between return and risk of the asset. This definition is given in books. Collectively it is somewhat indiscernible. We will dissect the definition. It is commonly known that the higher the risk, the higher the return. Now, suppose we know how much risky the asset is. This model will show us how much return should be there for the asset. This return is usually known as required rate of return and it is helpful to fairly evaluate the asset. This required rate of return can be compared with estimated rate of return. Thus, we will be able to know whether the asset is fairly evaluated or not. To understand relationship between risk and returns of the asset, Security Market Line (SML) can be used. Mr. Sharpe has created this CAPM model and to make it easily operational, he has made some assumptions. These assumptions may seem unrealistic, but to explain any economic or finance theory, they are essential. Market efficiency Sharpe has assumed that market is efficient, which means everyone reads either Economic Times or Business Standard or Mint and has all information about market and her/his shares. Everyone holds small amount of wealth and s/he cannot influence market. One holds handful of water and the market is an ocean. Risk aversion and......

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