Download file to see previous pages...
The information of risk observed in similar types of the asset in the market will help the investor to get a true picture towards acquiring the asset. The observed risk factors will help in determining the real value of that asset (Kerzner & Saladis, 2010).
There are many small investors who are the price taker. There is no tax on the asset. Investment should be of public related assets for example: shares and bonds. All the investors are adopting same strategy and provide combine information about the asset (Fabozzi et al., 2006).
Investor can get information from the market to apply CAPM model, but it is also possible that the information is incomplete or not at large practiced. The investors in market applying CAPM pricing model are basically small investors. Small investors usually buy little bit stocks of asset and sell if the price of that asset increased (Kürschner, 2008). The risk factor cannot be perfectly determined by the small investors because they acquire the assets on equilibrium price set by the market. Small investors can take risk but valuable risk factor can be determined by the large investors. Although tax on the asset is generally added to the cost of the asset but in determining the price model of CAPM, the tax factor will not be included. The information regarding the particular asset does not contain the information of tax imposed on it (Loskamp, 2007).
APT is the model which can provide well diversified information about the risk factors as well as expected returns of that asset. Agents are appointed under this model to get information quite reliable regarding the risk and returns of an asset. Agent provides the expected returns of the asset depending on his experience. Risk factor calculated by the agent is more preferable because it is actually based on the whole market review (Focardi & Fabozzi, 2004). The agents charge price for providing information of the asset. Investor has to choose the agent which has the
...Download file to see next pagesRead More
Thus, it is the relevant measure of risk. As risk increases so does the required rate of return and market risk premium is the difference between the required rate of return on a portfolio minus the risk free rate multiplied by the beta of that stock. RPs = (km –krf) bs The basic assumptions of CAPM are that investors choose among portfolios to maximize their return and wealth.
Accordingly the equation used for CAPM is: E(Ri) =RF +?i [E(RM) - RF ] (CAPM: Theory, Advantages and Disadvantages, 2008) However, there are many limitations as the assumptions can cause certain deviation in the application of this process, between the reality and the model.
The model assumes that the lending rate and the borrowing rate are equal. In practice, these two rates differ and therefore, the model will not hold in a real life scenario. also Also it assumes that there is no transaction cost, taxes or holding period of the securities.
It is essentially used to price the most risky assets. As a mathematical model for equilibrium in financial markets and portfolio theory (Markowitz), the CAPM core basis is the relationship that exists between the risk of a security and its yield, and it is measured through a single beta factor for risk (Plesmann, 2010.p.54).
According to the CAPM, the relation between the expected return on a given asset i, and the expected return on a proxy market portfolio m is given as:
APT holds that the expected return of a financial asset can be modelled as a linear function of various macro-economic factors, where sensitivity to changes in each factor is represented by a factor specific beta coefficient.
But even with all these scientific models developed by humans the financial market still remains turbulent and unpredictable so far. The challenges that the financial asset pricing models face are many. Although these models have evolved consistently since its inception in early 1960s the empirical record of these models are not very encouraging to use it in practice.
The idea of investing in the financial market is to purchase the asset while the price is low, and to sell when the price appreciates.
The seeming arbitrary movement of prices of assets, such as stocks, has
Observing that the Markowitz model fails to account for risk, simultaneous although separate studies by Jack Treynor (1961), William Sharpe (1964), John Lintner (1965), and Jan Mossin (1966) arrived at what eventually became known as the Capital Asset Pricing
because of this assumption, it is assumed that there is no information asymmetry in the market, implying that all investors have the same publicly available information concerning securities in the market. Thus, since investors have similar information, the models assume that
4 Pages(1000 words)Essay
GOT A TRICKY QUESTION? RECEIVE AN ANSWER FROM STUDENTS LIKE YOU!
Let us find you another Essay on topic Asset pricing models (CAPM and APT) for FREE!