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# CAPM and its significance

Extracts from this document...

Introduction

CAPM and its significance Introduction In almost every economics textbooks (Ben and Robert, 2001), economists tend to argue: everything's market price is determined by consumers' demand and supply in the market, the intersection of which gives us the long-term concept of 'market equilibrium'. Although it sounds straightforward, it is anything but easy in practice, especially when the assets (like common stock) you are measuring associated with risk and future uncertainties. Fortunately, economists and financial analysts have developed plenty of theories to help us explain how the risk for market assets can be appropriately measured in our life. Capital Asset Pricing Model ('CAPM') is one of the most influential and applicable models, which give good explanations and predictions of 'market price for risk'. This essay is going to look at what the CAPM really is, how it is derived and used, and will also see some limitations of applying it in practice. Assumptions First of all, we have to make some assumptions here, as the CAPM is developed in a hypothetical world, as written in the theory of business finance (Archer and Ambrosio, 1970): * Investors are risk-averse individuals who maximize the expected utility of their end-period wealth. * Investors are price takers and have homogeneous expectations about asset returns that have a joint normal distribution. * There exists a risk-free asset such that investors may borrow or lend unlimited amounts at the risk free rate. * The quantities of assets are fixed. ...read more.

Middle

Therefore, the percentage 'a' in the above equations is the excess demand for an individual risky asset, where it should be equal to zero. Simplifying previous equations, by substituting 'a = 0', we could get: ?E(Rp) / ?a = E(Ri) - E(Rm) -------1 ??(Rp)/ ?a = (?im - ?m2) / ?m --------2 Then, by dividing equation '1' by '2', we could arrive at the slope of the risk-return trade-off evaluated at point M, in the market equilibrium, is By the same token, as the capital market line is also an equilibrium relationship, given market efficiency, the tangency portfolio must be the market portfolio where all assets are held according to their market value weights. We can use the same method to derive the slope of the capital market line shown as follow: E(Rm) - Rf ?m (Where ?m is the standard deviation of the market portfolio) In the tangency point (pint 'T' in the graph), the slope of market efficient portfolio curve should be equal to the slope of capital market line. Therefore, by equating the slopes together and rearranging, the final relationship can be obtained: E(Ri) = Rf + [R(Rm) - Rf] ?im / ?m2 This is known as the Capital Asset Pricing Model (CAPM). The equation is also shown graphically below, where it is also called the security market line. The 'BETA' here is simply the covariance between returns on risky asset and market portfolio. ...read more.

Conclusion

In addition, empirical testing of the CAPM and the birth of post form, which introduce errors in the end of the equation, suggested that although the CAPM does not conform to the reality, it does give accurate long-term predictions and trends of what is going on in the real financial market. For short, the Capital Asset Pricing Model is the best-known model of risk and return, which is plausible and widely used but far from perfect. Conclusion All in all, although the CAPM is imperfect, it does give us significant implications and ideas of 'how risk is measured and priced in the market'. It also helps us with investment decision-makings and corporate policies. Therefore, having recognized its problems, we should accept it as the 'one of the best but imperfect solutions'. Bibliographies Archer, S. and Ambrosio, C. (1970). The theory of business finance. The McMillan company. New York. Brealey, R. and Myers, S. (2003). Principles of Corporate Finance. McGraw - Hill. Brian, B. and Butler, D. (1993). A dictionary of Finance and Banking. Oxford University Press Ben, S. and Robert, H. (2001). Principles of Economics. McGraw-Hill. New York. Copeland, T and Weston, J. (1946). Financial theory and corporate policy. Addison-Wesley publishing company. USA. Frank, R. (2003). Microeconomics and behaviour. McGraw - Hill. Markowitz, H. (1952). 'Portfolio Selection'. Journal of Finance. 7:77 - 91 March. Horne, V. (1983). Financial management and policy. Prentice-Hall International. Sharpe, W. (1964). 'Capital Asset Prices: a theory of market equilibrium under conditions of risk.' Journal of Finance. 19: 425 - 442 (September). ...read more.

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