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What Is The CAPM (Capital Asset Pricing Model) And Of What Practical Use Is It - Essay Example

Extract of sample What Is The CAPM (Capital Asset Pricing Model) And Of What Practical Use Is It

When the expected return of a security is determined using the model then it can be compared to the estimated return of security over a given time period. Such comparison will help the investor to analyse whether it is worthwhile investing into the security. CAPM was first conceptualised and pioneered by William Sharpe, Jack Treynor, Jan Mossin and John Lintner through their independent works (Focardi and Fabozzi, 2004, pp.86-87). The Capital Asset Pricing Model The Capital Asset Pricing Model (CAPM) is popularly used to price individual portfolio securities. The CAPM helps to determine the expected rate of return for an asset relative to market risk. Using the CAPM model an investor can eliminate the unsystematic risk through proper diversification by estimating the required rate of return for a given level of non-diversifiable or market risk. The practical application of the model is that the individual investor will be able to modify their investment portfolio according to their risk taking behaviour. The model also helps the individuals to analyse the risk-return profile in the portfolio (Gallagher and Andrew, 2007, pp.173-175). Assumptions of CAPM Investors are risk averse and rational No single investor can influence security prices No transaction cost or taxes Investors have access to all information at same time Expectation of the investors is homogeneous Mathematical Formula For individual assets, the relation between systematic risk and expected return can be estimated using the Security Market Line (SML). The significance of SML is that it can help the investor to calculate the risk-to-reward ratio for a given security relative to market. (Source: Financial Planning Body of Knowledge, 2010) The market risk-reward ratio is also known as the market risk premium. The systematic risk can be estimated using the Beta factor (?). Beta measures the sensitivity of excess expected return of security to the excess market return. Mathematically, ? = Covariance (Ri, Rm) / Variance (Rm) Excess market return or Risk Premium = E (Rm) – Rf CAPM = Rf + ? x [E (Rm) – Rf] Where, Rf = Risk-free return Ri = Security Return Rm = Market Return Market Portfolio and Efficient Frontier The concept of CAPM encourages an investor to invest a portion of his or her wealth in risky asset and the remaining portion into risk-free asset. The proportion of asset allocation between risky and risk-free asset depends on the behaviour of the investor. According to this model, a rational investor will prefer maximum return for given risk or minimum risk for given return. The optimum portfolio is a combination of securities which yields maximum returns for lowest risk or volatility. The total portfolio risk can be measured and compared to market risk using beta. The optimum portfolio is derived from the efficient frontier curve that gives the relation between portfolio risk and return. The combination of securities that is formed at the tangency of individual assets and the capital Allocation line (CAL) is called the optimal portfolio (Khan and Jain, 2007, p.16). (Source: krotscheck.net, 2008) The Significance of Beta Factor Beta indicates the stock volatility relative to a benchmark or market. The benchmark can be international index like S&P ...Show more

Summary

The total risk of portfolio can be divided into systematic (non-diversifiable) and unsystematic (diversifiable) risk. An investor can reduce the unsystematic risk of investment through proper diversification of securities in the portfolio…
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