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CAPM is popular because of its simplicity and utility at various problems. CAPM is used to quantify the risk associated with the assets and then translate it into the returns associated with the securities (Mullins 2012).
CAPM is actually used to make calculations of a single security. The formula is very simple which is used in calculations. It includes the expected return on the capital assets, risk free rate of interest, market risk which is denoted by beta, market premium and the risk premium. Now the description of all of these components is given as follow;
Here beta or the market risk is very important. Every company also has its own beta value which is useful for every type of calculations. A specific company’s beta value means the risk associated with the company but in comparison with the whole operational market. But when we talk about beta in capital asset pricing model i.e. CAPM then it means the market risk which any company must face during their cost and return calculations. By definition the value of beta is equal to 1.0.
The application of CAPM gives its best results when all of the above assumptions are met in an appropriate environment. These assumptions are made regarding a generalized conditional environment. Whenever any specific different situation may come and the investor may feel any difficulty then the researchers start their duty and find any other way to solve the problem. Therefore we may see certain modified versions of theories and models. The basic theme and assumptions of these theories and models is same only the operational side may be modified according to the situations. Some critics are of the opinion that CAPM assumptions are totally unrealistic, but still there are many supporters of this model of capital asset pricing model.
From the very beginning (i.e. just after introducing CAPM), the
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CAPM and Its Practical Use.
CAPM refers to the capital asset pricing model, a widely adopted model within the financial field in order to determine the value of the appropriate rate of return for an asset. Generally speaking, the model has been extensively adopted by portfolio managers and by financial analysts in order to infer asset required and expected returns on a standardized basis.
In 1929 stock market crash, investors in today’s money, lost $319 billion dollars (Time U.S. 2008). The Black Monday of 1987 was the largest one-day market crash in the history. On October 19, 1987, Dow lost 22.6 % of its value or $500 billion dollars (Stock Market Crash n.d.).
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. Since systematic risk cannot be eliminated, the capital asset pricing model (CAPM) can be used as a tool to determine expected return of asset that is chosen to be added in a well diversified portfolio.
Capital Asset Pricing Model.
CAPM (Capital Asset Pricing Model) The CAPM model has emerged to be one of the most important tools in making a fundamental decision related to the investment management. It measures the relationship between the expected rate of return and the risk involved in a particular investment The CAPM tool signifies the linear relationship between the non diversified systematic risks which is measured by beta ?
The formula is given as: risk free rate added to beta multiplied by the difference of market return and risk free rate.
Beta in this case represents a stock’s rate of rise and fall in comparison to the market in general. It is a measure of the sensitivity of an assets
Risk free return is considered to be the representation of time value of money in the formula for the Capital Asset Pricing Model. It is considered to deal with compensating investors for making an investment and holding it for a period of time. The model is also
The paper "Capital asset pricing model (CAPM)" gives the detailed information about Developments in the Capital Asset Pricing Model. The foundation of Capital asset pricing model was established in an article of a finance journal in the year 1963 named, Capital Asset Prices: A theory of market equilibrium under conditions of risk.
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