CAPM and its significance

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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. Also, all assets are marketable and perfectly divisible.
  • Asset markets are frictionless and information is costless and simultaneously available to all investors.
  • There are no market imperfections.

Although not all these assumptions conform to reality, they are simplifications that permit the development of the CAPM.

Derivation of the CAPM

According to Financial theory and corporate policy (Copeland and Weston, 1946), the CAPM is based on Harry Markowitz’s early portfolio theory (1952) which showed how an investor can reduce the standard deviation of portfolio returns by choosing stocks that do not move exactly together (Brealey and Myers, 2003). Thereafter, William Sharpe (1963) stimulated all possible combinations of stocks in the market, getting a graph similar to Figure 1a below. Because of the one of the golden rules in finance: ‘investors prefer higher return but low risk (deviation)’, there must be some efficient portfolios that best satisfies different investors’ preferences, which has been illustrated in Figure 1b.

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Here in figure 1b, all the points along the ‘efficient curve’ provide investors with best return given certain risk level. It is a matter of different preferences which are up to individuals’ different utility function (Frank, 2003) and determine which to choose for different investors. However, if an alternative investment opportunity is introduced where investors can freely invest and borrow at risk free rate, we simply conjured more efficient market opportunities where a line starts from risk free point and also tangents the ‘efficient curve’ (illustrated in graph below).

Written in Principles of Corporate Finance (Brealey ...

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