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Capital Asset Pricing Model (CAPM)

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Added on  2021-05-27

Capital Asset Pricing Model (CAPM)

   Added on 2021-05-27

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CAPM 1Capital asset pricing model (CAPM)by Student NameThe Name of the Class (Course)ProfessorThe Name of the UniversityThe City & StateDate
Capital Asset Pricing Model (CAPM)_1
CAPM 2Capital asset pricing model (CAPM)IntroductionThe Capital asset pricing model (CAPM) is a beneficial model, and it is used widely in theindustry even though it is based on extreme assumptions. In line with this statement, thispaper seeks to investigate on the issues surrounding CAPM as a financial/ investment conceptheavily relied upon by the investors in the economic and investment markets. Specifically,the study seeks to address the specific issues surrounding CAPM such as its definition, keyassumptions, criticisms and limitations, other alternative financial models that can be used inplace of CAPM and the application of CAPM.Description of CAPMThe Capital Asset Pricing Model (CAPM) is a financial/ investment model used by to evaluate the relationship between expected returns and risks associated with an investment. Inthe real world, investors take up investment risks with a hope of higher returns(Fama & French, 2004, p. 27). The CAPM model demonstrates that the expected return should be equivalent to the risk premium plus risk-free returns based of the beta of a given investment. The linear relationship between the expected return and its systematic risk is presented as below;
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CAPM 3The CAPM is calculated using the formula shown below:Where; R = Expected return Rf = Risk-free rateβ = Beta of the investmentRm = Expected return on the marketNote: (Rm – Rf) refers to the Risk Premium of the investment.The CAPM formula is applied when calculating the return associated with an investment. Themethod is based on the proposition that investors accept systematic/ market risk hence they R= [Rf + β (Rm – Rf)]
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CAPM 4should be compensated using risk premium. In simple terms, investors expect higher returns for taking additional risks after investing in an asset (Graham & Harvey, 2001, p. 190). The CAPM variables cab be defined as below:a)Expected return (R): The notation "R" stands for the expected return from a capital investment over time. The expected return is dependent on the other three variables. According to the CAPM model, the expected return is measured using a long-term period, for example, the entire life of the capital asset (Ang, et al., 2006, p. 261). b)Risk-free rate (Rf): The notation "Rf" represent risk-free rate which is equivalent to the return from a 10-year government bond. A 10-year bond is mostly used to measure the risk-free rate associated with a capital investment because it is most liquid and heavily quoted in the investment market (Lewellen & Nagel, 2006, p. 300).c)Beta (β): The notation "β" represents beta which measures the degree of risks associated with a stock. Beta can be obtained by establishing the degree at which the price of a stock fluctuates relative to the market price. For example, if the beta of a company is 1.5 relative to the market's 1, therefore the company has a volatility rate of 150%. In other words, beta measures the sensitivity of an investment to the market risks. d)Premium market risk (Rm): The notation "Rm" represents the premium market risk which is obtained by subtracting the risk-free rate from the expected return. The variable represents the excess return that an investor would realize by accepting additional investment risk (Banz, 1981, p. 12). CAPM calculationSuppose you have been provided with the following information:A stock trades in the Singapore stock exchange market.
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