The Capital Asset Pricing Model (CAPM)
For an open market place, an idealized framework is assumed. In this market, stocks available for trade are assumed to risky assets.
However lending has an interest rate attached to it. In the open market, it is also assumed that traders have all relevant information rates of stocks and other co-variances. Traders in an open market are also assumed to be rationale about being risk averse and all investors have same assets to choose from given all information concerning the assets and same decision methods are applied (Burton, 1998). This brings us to the concept of the capital asset pricing model (CAPM). The model is very useful and is widely used in the industry, although it is based on very strong assumptions. This paper will focus on brief theory of arbitrage theory of the CAPM model, main theories behind this model and their critique.
First, the model is quite useful as it focuses on determining the required rate of return appropriate for a company’s assets. The model requires various firms to have a portfolio that is well diversified, as long as the risks prone to the assets cannot be diversified (Brealey, et al 2009). Practically, most companies utilize CAPM model to determine the price of a security or a portfolio. In this case, a security market line that defines the relationship existing between the beta and expected rate of return of an asset is utilized. ...