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Outline and discuss the Capital Asset Pricing Model (CAPM) as means of valuing securities and their risk. What are the drawbacks - Essay Example
Author : demarioauer
Finance & Accounting
Pages 8 (2008 words)
Outline and discuss the Capital Asset Pricing Model (CAPM) as means of valuing securities and their risk. What are the drawbacks with the CAPM and how does it compare and interact with the dividend valuation model? Introduction Capital Asset Pricing Model (CAPM) is a quantitative tool for analyzing the return of a particular security with the risk associated of that particular security with respect to the overall market risk (Ashbaugh and Pincus, 2001)…
Some other financial experts like Lintner and Mossini also explained and purified CAPM and its interpretation in later years (Gassen, and Sellhorn, 2006). Capital Asset Pricing Model Being a quantitative tool for computing the yield of a security, CAPM is used for pricing the financial asset through mathematical calculations (Fields and Vincent, 2001). There are three main components of CAPM model which are stated as follows: Rf = Risk-free rate Beta = Risk of individual security with respect to market Rm – Rf = Market Risk Premium Risk-free Rate Risk free rate is considered as the rate at which the investor does not face any risk yet he obtains a specified return. This risk-free return can be obtained by investing in government securities which are considered are risk free. However, the term risk-free is referred to only the risk related to default risk. Since governments are considered as the ones which are not supposed to face default risk, therefore, their securities are considered as risk-free securities (Babu, 2012). Beta Beta is the factor which indicates the risk of a particular security associated with the overall market risk (Vishwanath, 2007). ...
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