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CAPM

The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return, aiding in the pricing of risky securities and investment decisions. It is based on several assumptions, including homogeneous expectations and market efficiency, but has limitations such as unrealistic premises and unstable betas. CAPM utilizes components like the risk-free rate, market risk premium, and beta to calculate expected returns on investments.

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14 views10 pages

CAPM

The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return, aiding in the pricing of risky securities and investment decisions. It is based on several assumptions, including homogeneous expectations and market efficiency, but has limitations such as unrealistic premises and unstable betas. CAPM utilizes components like the risk-free rate, market risk premium, and beta to calculate expected returns on investments.

Uploaded by

sijoabraham1801
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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CAPM:

CAPITAL ASSET PRICING


MODEL
CAPM:
❑ A model that describes the relationship between risk and expected
return and that is used in the pricing of risky securities.
❑The model was introduced by Jack Treynor, William Sharpe, John
Lintner and Jan Mossin independently, building on the earlier work
of Harry Markowitz on diversification and modern portfolio theory.
❑ The general idea behind CAPM is that investors need to be
compensated in two ways: time value of money and risk.
It's a cornerstone of modern portfolio theory and is widely used in
finance to:
● Price assets
● Make investment decisions
● Calculate the cost of equity capital
❑
No matter how much we diversify our investments, it's
impossible to get rid of all the risk.
As investors, we deserve a rate of return that compensates
us for taking on risk.
The capital asset pricing model (CAPM) helps us to calculate
investment risk and what return on investment we should
expect
CAPM is more accurate in the short term.
Assumptions -
Homogeneous Expectations: CAPM assumes all investors have identical expectations
regarding market returns and risk. In reality, investors have diverse views and risk
tolerances.
Risk-Free Rate Assumption: The assumption of a risk-free rate of return available to all
investors is unrealistic. Borrowing and lending rates vary across individuals and
institutions.
Market Efficiency: The model assumes perfectly efficient markets where all information is
instantly reflected in asset prices. Market inefficiencies, such as behavioral biases and
information asymmetry, do exist.
Single-Factor Model: CAPM considers only one risk factor: systematic risk (beta).
However, other factors, such as size, value, and momentum, have been shown to
influence stock returns.
Components -
Risk-Free Rate (Rf): The theoretical rate of return of an investment with zero risk,
often represented by the yield on short-term government bonds.

Market Risk Premium (Rm - Rf): The excess return that investors expect to earn
from investing in the market portfolio compared to the risk-free rate.

Beta (β): A measure of a stock's volatility relative to the overall market. A beta of
1 indicates that the stock's price will move in line with the market. A beta greater
than 1 suggests higher volatility, while a beta less than 1 implies lower volatility
BETA
A measure of the volatility, or systematic risk, of a
security or a portfolio in comparison to the market as
a whole.
Beta is used in the capital asset pricing model
(CAPM), a model that calculates the expected return
of an asset based on its beta and expected market
returns.
Also known as "beta coefficient.“
LIMITATIONS
CAPM has the following limitations:
It is based on unrealistic assumptions.
It is difficult to test the validity of CAPM.
Betas do not remain stable over time

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