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Capital Asset Pricing Model (CAPM)—a Cookbook Recipe Approach Assignment Help
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The Capital Asset Pricing Model is used to determine the rate of return on a risky asset. It ascertains the relation between systemic risk and expected rate of returns. It determines expected returns of assets with the risk of those assets and also calculates the cost of capital. It can be used both for pricing a portfolio or an individual security.
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Assumptions on which CAPM is based
- Investors can invest at zero risk rate.
- Short sales can be made freely.
- There is no taxation on investments and zero transaction costs.
- Investor choices don’t affect market prices.
- Investments give an expected return and follow standard deviation.
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The Formula
r* = KRF + b(KM – KRF)
r*=required rate of return
KRF= the risk-free rate, example short-term government issued T-Bills
KM=average market return
The b=beta coefficient of security, for example, b>1 signifies risk higher than the market average and b<1 implies risk below market average.Most companies lie in the range of 0.75 to 1.50.
This called the Security Market Line Formula (SML) used for individual securities. The SML enables us to find the reward to risk ratio with the overall market.
Example to calculate the required rate of return using the CAPM
Consider the following information:
Risk-free rate of return = 5%
Average Market Return = 6%
Beta value of RD Co = 1.3
Using the CAPM:
r* = KRF + b(KM – KRF)= 5 + (1.3 x 6) = 12.8%
The CAPM predicts that the cost of equity at 12.8%.
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Disadvantages of CAPM Model
- The CAPM Model assumes that the variance is adequate to measure risk, but in reality, the variance is asymmetric in nature.
- It fails to explain in details the variation in stock returns around the world.
- It assumes that investors would always take a lower risk. Gamblers always take a higher risk contrary to CAPM.
- The CAPM Model assumes that there are no transaction costs or taxes involved which is always not the case.
- There is no chance to rebalance the portfolio with time. So, in these cases of adjustment Inter Temporal CAPM is used.
- It assumes that investors will only optimize one portfolio, but people tend to have fragmented or multiple portfolios.
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