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Finance & Accounting
Pages 6 (1506 words)
Corporate Finance Table of Contents Capital Asset Pricing Model (CAPM) 3 Parameters of CAPM 5 Application of Capital Asset Pricing Model in Corporate Decision making 6 Outline of Three Factor Model by Fama and French 7 Assessment of CAPM 9 Reference List 11 Capital Asset Pricing Model (CAPM) After Markowitz (1952) had constructed the Modern Portfolio Theory, a large number of models have been developed, which related the excess return of the portfolio with the excess market portfolio returns.
Blume (1993) had suggested that CAPM provides a model of equilibrium risk/return relationship. The CAPM also denotes that there exists a linear relationship between expected return and non-diversifiable systematic risk which is denoted as beta. This linear relationship is denoted as security market line (SML). In SML, the systematic risk of a share is compared with the risk and return of the market as well as the risk free rate of return for estimating the expected return of a particular share (Arnold, 2008; Pike and Neale, 1999). Figure 1 Source: (Ogilvie, 2008) CAPM defines risk as an extent to which the return of the portfolio of shares or a single share has a covariance with the return in the market. If it is assumed that CAPM correctly defines the capital market, then the risk/return relationship can be established for an efficient market strategy. The CAPM equation represents this relationship and expected return is seen to be a function of the following equation: R = Rf + ? (Rm – Rf) Where: R = Expected return on the portfolio or share. Rf = Risk-free rate of return. ? = Beta. ...
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