StudentShare
Contact Us
Sign In / Sign Up for FREE
Search
Go to advanced search...
Free

Capital Asset Pricing Model - Essay Example

Cite this document
Summary
The paper "Capital Asset Pricing Model" discusses that CAPM is just a model, not an exact copy of the validity. Actually many researchers deny its value as they consider that some tendencies of dynamics of profitableness of stocks are not in accord with this model…
Download full paper File format: .doc, available for editing
GRAB THE BEST PAPER91.8% of users find it useful
Capital Asset Pricing Model
Read Text Preview

Extract of sample "Capital Asset Pricing Model"

Introduction One of characteristic features of economic relations is a pragmatism of its participants. Any value of material or non-material character in such relations is interesting only in case it promotes achievement of any purposes, first of all of economic character. The basis of business activity is the increase of economic potential of a company. On investing the capital in any investment project the businessman believes that after some time he will not only compensate the invested capital, but also to receive the certain profit. An estimation of this profit is based on forecasts of the future taking from the investment. Any investment decision is based on: an estimation of own financial condition and expediency of participation in investment activity; an estimation of the size of investments and sources of financing; an estimation of the future taking from realization of the project. The concept of enterprise and financial risk consists in the fact that the perspective decision of financial character has the stochastic nature, being hence subjective, and the degree of its objectivity depends on different factors, including accuracy of predicted dynamics of a monetary flow, the price of sources, opportunities of their reception, etc. In the basis of such estimations lay statistical data. Any financial manager constantly faces a problem of a choice of sources of financing. The particular feature of the problem moreover consists in the fact that that service of this or that source manages to the company unequally. Each source of financing has the price, and this price can have the stochastic nature. Decisions of the financial character are as efficient as good and objective the information base is. The level of objectivity depends on in what degree the market of capitals corresponds to the effective market. Capital Asset Pricing Model. Pro and Contra. Capital Asset Pricing Model (CAPM), the model of an estimation of profitability of financial assets, forms a theoretical basis for some various financial technologies on management of profitableness and risk, applied at long-term and intermediate term investment in stock. CAPM considers profitableness of the stock depending on behaviour of the market as a whole. Other initial assumption of CAPM consists in the fact that investors make decisions, considering only two factors: expected profitableness and risk. Though this model is the simplified representation of the financial market, it is widely used in the activity of many large investment structures, for example Merrill Lynch and Value Line. The euphoria of researchers in the sixties and seventies about the validity of weak and medium-strong EMH has been weakened by the relatively poor empirical validation of the standard CAPM and a variety of excess returns of indexed price anomalies Even if the analytical sources of error found under (1) that relativize inefficiency are eliminated, fundamental criticism of the CAPM is still advanced1. According to the model the risk connected with investments into any risk financial object, can be of two kinds: systematic and non-systematic. The systematic risk is caused by the general market and economic changes influencing all investment objects and not being unique for a concrete asset. Non-systematic risk is connected with the concrete issuer company. It is impossible to reduce systematic risk, but it is possible to measure the influence of the market on the profitableness of financial assets. As a measure of systematic risk in CAPM the (Beta) parameter is used. It describes the sensitivity of a financial asset with respect to changes of market profitableness. Knowing the parameter it is possible to quantitatively estimate the value of the risk connected with price changes of all market as a whole. The more value of a stock , the more its price rises at the general growth of the market, and on the contrary. Non-systematic risk can be reduced by means of a well-diversified portfolio. The nice calculation of showing is necessary for financial managers to choose assets, which in the best way correspond to their strategy of investment. Using coefficient it is possible to form investment portfolios of the most different types: conservative, aggressive, balanced2. The CAMP formula is: Expected Security Return = Riskless Return + Beta x (Expected Market Risk Premium) or: r = Rf + Beta x (RM - Rf) Another version of the formula is: r - Rf = Beta x (RM - Rf) where: r is the expected return rate on a security; Rf is the rate of a risk-free investment, i.e. Cash; RM is the return rate of the appropriate asset class. Beta is the overall risk in investing in a large market3. As any other model CAPM has its advantages and disadvantages. The basic lacks of CAPM method are connected with factor, which: Shows comparative volatility of shares of the company in relation to the market as a whole (thus the company, which shares go up on the 'falling' market, will have 'bad ' and accordingly the high discount); Reflects market risks of shares of the company, instead of risks of its business that the rate of discounting should do. If it is supposed that the market soon will start to fall, how we can choose the discount for the company with , close to 1 And what will be, if there is a crisis not in the share market, but on commodity markets of the company or in the market of raw material for it; Is retrospective. In other words it considers the history of the company (more precisely, one of its components) while the rate of discounting is perspective as corrects possible miscalculations of an analyst at the forecasting the future monetary flows. Whereas some see "damning evidence" (as does Haugen4) others concede that "although we couldn't tell whether it was true or not, it does give us insight into behavior in capital markets" (cf. Elton, Gruber, Brown, and Goetzmann5). CAPM is not the theoretical model of expected profitability. It is competed by some models, in which expected profitability depends on beta of shares with respect to greater quantity of factors, than just a market. These factors can be both macroeconomic variables (for example, the five-factor model developed Chen, N. F., R. R. Roll, and S. A. Ross), or the portfolios generated on the basis of characteristics of the companies (for example, three-factor model developed by Eugene Fama and Kenneth French ), or even sequence of parameters of the profitability constructed with the use of methods of statistics, such as the factor analysis. According to Focardi & Fabozzi hence, Roll submits that the CAPM is not testable until the exact composition of the true market portfolio is known, and the only valid test of the CAPM is to observe whether the cx ante true market portfolio is mean-variance efficient. As a result of his findings, Roll states that he does not believe there ever will be an unambiguous test of the CAPM. He does not say that the CAPM is invalid. Rather, Roll says that there is likely to be no unambiguous way to test the CAPM and its implications due to the nonobservability of the true market portfolio and its characteristics6. The euphoria of researchers in the sixties and seventies about the validity of weak and medium-strong EMH has been weakened by the relatively poor empirical validation of the standard CAPM and a variety of excess returns of indexed price anomalies Even if the analytical sources of error found under (1) that relativize inefficiency are eliminated, fundamental criticism of the CAPM is still advanced. Conclusion There is no doubt that the CAPM model has a great influence on the finance area. The impact that the model has made in the area of finance is readily evident in the prevalent use of the word 'beta'. In contemporary finance vernacular, beta is not just a nondescript Greek letter, but its use carries with it all the import and implications of its CAPM definitions. CAPM is just a model, not an exact copy of the validity. Actually many researchers deny its value as they consider that some tendencies of dynamics of profitableness of stocks are not in accord with with this model. Does it mean that we should reject CAPM and rely only on the estimated parameters not connected with it, such as average selective profitableness By no means! Each model 'is mistaken', almost by it definition as it is based on the simplified assumptions about our complex world. But even the inexact model can be quite useful. Here we shoul recollect Bayesian Approach and combine everything that we get from data with our best initial guess. We may agree with Maringer, who stats that the question of whether the CAPM is valid or not is therefore still far from being answered7. Nowadays we may agree that the main criticism of the CAMP is not that it is wrong, but that it does not go far enough. References: "CAPM - Capital Asset Pricing Model." 12manage.com. 2000. 12 manage - Online Executive Education. 20 Apr. 2007 . "CAPM. Does it help to forecast stock market." e-MasterTrade. 19 Apr. 2007 . Elton E.J, Gruber M.J. Brown S.J. Goetzmann W.N. Modern Portfolio Theory and Investment Analysis, sixth ed. John Wiley & Sons. New York, 2003 Focardi, Sergio, and Frank J.Fabozzi. The Mathematics of Financial Modeling and Investment Management . John Wiley and Sons, 2004. Haugen, R.A.Modern Investment Theory. Prenctice Hall, London et al., 5th edn, 2001. Maringer, Dietmar. Portfolio Management with Heuristic Optimization. Springer, 2005. Tolksdorf, Norbert, and Lukas Menkhoff. Financial Market Drift: Decoupling of the Financial Sector from the Real Economy . Springer, 2001. Vidyamurthy, Ganapathy. Pairs Trading: Quantitative Methods and Analysis . John Wiley and Sons, 2004. Read More
Cite this document
  • APA
  • MLA
  • CHICAGO
(Capital Asset Pricing Model Essay Example | Topics and Well Written Essays - 1750 words, n.d.)
Capital Asset Pricing Model Essay Example | Topics and Well Written Essays - 1750 words. https://studentshare.org/macro-microeconomics/1502666-capital-asset-pricing-model-pro-and-contra
(Capital Asset Pricing Model Essay Example | Topics and Well Written Essays - 1750 Words)
Capital Asset Pricing Model Essay Example | Topics and Well Written Essays - 1750 Words. https://studentshare.org/macro-microeconomics/1502666-capital-asset-pricing-model-pro-and-contra.
“Capital Asset Pricing Model Essay Example | Topics and Well Written Essays - 1750 Words”. https://studentshare.org/macro-microeconomics/1502666-capital-asset-pricing-model-pro-and-contra.
  • Cited: 0 times

CHECK THESE SAMPLES OF Capital Asset Pricing Model

Maritsa Plcs Using the Capital Asset Pricing Model

An essay "Maritsa Plc's Using the Capital Asset Pricing Model" reports that the method of capital budgeting is widely used because of its recognition of the time value of money....  … The Capital Asset Pricing Model (CAPM) is one of the most popular tools in finance which is used to determine a theoretically required rate of return of an asset, if that asset is added to an already well-diversified portfolio, given the asset's non-diversifiable risk....
7 Pages (1750 words) Essay

The Capital Asset Pricing Model Theory

From the paper "The Cаpitаl Аsset pricing model Theory " it is clear that the CАPM, like Mаrkowitz' portfolio model on which it is built, is nevertheless а theoreticаl tour de force.... The cаpitаl аsset pricing model (CАPM) theory аssumes thаt аn investor expects а yield on а certаin security equivаlent to the risk-free rаte (sаy thаt rаte аchievаble on six-month Treаsury bills) plus а premium bаsed on mаrket vаriаbility of return X а mаrket risk premium....
10 Pages (2500 words) Coursework

Capital Mobilization and Capital Asset Pricing Model

The author of the paper also discusses the relevance of the Capital Asset Pricing Model ( CAPM) to the company seeking to evaluate its cost of capital.... The author of the paper explains how large companies raise capital from the equity and bond markets.... hellip; Banz in 1981 challenged the relevance of CAPM with empirical evidence showing stocks of smaller firms earning a higher return than forecast by the CAPM....
9 Pages (2250 words) Term Paper

About Capital Asset Pricing Model

The case study "About Capital Asset Pricing Model" states that Capital Asset Pricing Model (CAPM) has been at the heart of finance and it is the centerpiece of courses pertaining to finance.... nbsp;… Empirical evidence has not supported the Capital Asset Pricing Model but its theoretical and sound reasoning has attracted financial engineers.... Secondly, the model assumes that the assets are infinitely divisible.... CAPM has its roots build on the model of a portfolio developed by Markowitz in the late '50s....
7 Pages (1750 words) Case Study

Study of The Capital Asset Pricing Model (CAPM) 02165

The model aims at highlighting the expected returns on particular stock, which is identified after considering the risk free interest rate and risk premium.... This portfolio model helps in examining the risk-return relationship in capital market (Elton, et al, 2011; Blume The only condition followed in this case is the investor has to behave in conformity maintaining prescription of portfolio theory.... Therefore, the CAPM model has successfully examined the predictions, which are made for measuring the risk-return relationship of asset prices (Black, Jensen and Scholes, 1972)....
4 Pages (1000 words) Essay

Capital asset pricing model (CAPM)

hellip; 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.... The essay explores the CAPM model.... The CAPM model is still widely used by companies as an efficient model for computing cost of capital (Ko) on the basis of explanation that securities with higher betas offer higher return....
7 Pages (1750 words) Essay

The Dividend Growth Model and Capital Asset Pricing Model

The purpose of this discussion is to provide the reader with a more informed understanding of the Dividend Growth Model and CAPM (Capital Asset Pricing Model).... This model is given by the formula; Capital Asset Pricing Model or CAPM is a model that specifies the relationship between risk and required rate of return on assets held by an investor in a well-diversified portfolio.... This paper illustrates that the CAPM model can be used to calculate the possibilities of the growth of investment....
12 Pages (3000 words) Assignment

Capital Asset Pricing Model and Recent Developments

In the paper “Capital Asset Pricing Model and Recent Developments” the author analyses Capital Asset Pricing Model (CAPM), which has been a well-acknowledged methodology among the finance professionals as well as the investors since long.... CAPM or Capital Asset Pricing Model is the basic model.... hellip; The author states that the Capital Asset Pricing Model says about the expected return of individual security of the portfolio is dependent on the risk-free return and the market risk i....
7 Pages (1750 words) Assignment
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.
Contact Us