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Importance of CAPM (Capital Asset Pricing Model)

   

Added on  2023-01-19

6 Pages1310 Words66 Views
Finance
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Capital Asset Pricing Model
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Importance of CAPM (Capital Asset Pricing Model)_1

Introduction
The present paper is developed for analyzing and examining the significance of CAPM
model and is usefulness for determining the potential worth of an investment. The model of
CAPM is highly important in the field of financial management as it provides the investors the
impact on the returns of a profitability of stock in relation to the market volatility. In this
context, this paper is developed for providing an understanding of the importance of capital
asset pricing model and its contribution in carrying out risk assessment of a given portfolio of
securities.
Importance of CAPM (Capital Asset Pricing Model)
Investors and business firms face risk on every investment they made and calculating
the risk is the most important task that financial managers have to perform. There are mainly
two types of risk that business firms and investors face on their investment and these risks are
known as systematic risk and unsystematic risk. In this regards capital asset pricing model
proves to be best measure to estimate the required return on investments and also uses
systematic risk in the calculation so that best estimation of return can be defined (Damodaran,
2011).
The technique of Capital Asset Pricing Model (CAPM) is developed by William Sharpe
in mid 1960s for determination of the relation that exist between risk and return of an asset.
The model is founding extensive use by the investors in taking decisions in the context of
investing assets within a portfolio. CAPM represents the linier relationship between risk and
return that is required or expected on an investment. This investment can be made by the
investors in the company or investment made by the company in business operations. So it can
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Importance of CAPM (Capital Asset Pricing Model)_2

be said that CAPM model can be used by both investors and company to estimate their
required rate of return on their investment made. CAPM formula only takes into account the
systematic risk in form of Beta and it totally ignore the unsystematic risk as it is not possible to
measure and calculate the unsystematic risk (Davies and Crawford, 2011).
Linear relationship of risk and return is shown as below (Formula of CAPM model):
E(r i ) = r f + b i (RP m )
(Moles and Kidwekk, 2011)
In the above formula, expected rate of return or required rate of required is denoted as
E(ri). Expected rate of return is also called as cost of equity as this rate of return is the cost that
company bear while employing equity capital within the business. rf is used denote the risk
free rate that company earn on securities that has no risk and there return is fixed such as
government bonds etc. bi is used denote the beta variable and it denotes the systematic risk that
one bear on investing in equity capital or risk bearing securities. RPm refers to as market risk
premium which calculated as market rate less risk free rate (Krantz, 2016).
In order to understand the essence of capital asset pricing model, there is need to
understand the advantages of using the CAPM as very important model to calculate the
expected rate of return. Some advantages of capital asset pricing model have been described
below:
Capital asset pricing model take into account the systematic risk and do not focus on
unsystematic risk. Through use of diversified portfolio risk can be easily eliminated and
investors are only concerned about the systematic risk which is leftover after
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