CAPM: Theoretical model analysis

CAPM
[Type the document title]
Theoretical model analysis
PC-AS0197
University Name-

Table of Contents
Introduction.................................................................................................................................................2
Risk and return analysis in CAPM Model...................................................................................................2
Evaluation of the systematic, undiversified risk, and unsystematic risk......................................................3
Problems in the CAPM model.....................................................................................................................4
Critique of CAPM.......................................................................................................................................5
What are the main assumption of CAPM and why it is mostly used by investors as compared to other
financial analysis tool..................................................................................................................................6
Conclusion...................................................................................................................................................7
References...................................................................................................................................................8

Introduction
With the ramified economic changes, the use of capital assets pricing model has gained
momentum throughout the time. Investors have been using the CAPM model the cost of equity
of the company. The CAPM model has been used to evaluate the required rate of return of the
assets which could be used by investors to choose the particular asset. It is used mainly when
there is well-diversified portfolio. This Capital asset pricing model was developed in 1952 with
a view to find out the rate of return on the assets and according to that the decision about adding
or developing the assets in the business is taken. It helps investors to not only increase the overall
return on capital employed but also assist him to accept the one particular project which assists in
determining the project option which will give best possible outcomes. This model was faced
with many numerous empirical tests, and presences of many more advance assets pricing and
selection of portfolio method in the market. But this model carries some of the important and
unique feature which makes it very popular that is its simplicity and utility in different situations
and circumstances. In 1972 there were different version of CAPM was developed called black
CAPM or zero based CAPM Model. This version was very must strong against the empirical
testing which leads the organization to use the CAPM worldwide.
Risk and return analysis in CAPM Model
The CAPM model is used by organization to give the ranking to the project investment
options on the basis required rate of return, the net present value, profitability and internal rate of
return. This option is very much beneficial to make the best investment decision. In capital asset
pricing model, the pricing of the assets is been done to identity their present values. For
instance, if the organization finds out the expected rate of return is less than its cost of capital
then the project should not be accepted. They can then analyses the rate of return to the expected
rate from return after that the organization can find out whether to invest in this appropriate
investment or not. But while going through this process the organization have to make an
independent estimate than can be expected from the security in which they are interested to
invest this can be done through technical analysis techniques. The technical analysis is made so
that investors could choose which option would give best possible return from the possible
required rate of return. It is further analyzed that risk and return associated with the investment

decision should also be analyzed by the investors while accepting the project. There should be
proper equilibrium between the risk and return and by using the CAPM method; investors would
accept those project which will give higher return on the basis of the low amount of return.
Evaluation of the systematic, undiversified risk, and unsystematic risk
The risk also come in two forms that are systematic risk also called undiversified risk, and
unsystematic risk also called diversified risk. The systematic risk are those risk that are common
for all the security that are there in the market, risk will be there equal on all the security.
Unsystematic risks are those that are there on the individuals assets. The unsystematic risk can be
diversified to the smaller level by the involvement of the great number of assets in the portfolio.
But diversification in the systematic risk, it cannot be possible within the one market as whole
market is cover with the risk. The CPAM model help to find out the risk that can be transferred
and the risk can cannot be transfer so that it becomes easy for the organization to think forward
for their business.
As we know with the advantage of many model they carry some of the disadvantage
with them the CAPM model as it is cover up with some of the assumptions that decrease its
value with a bit in the market, and with the assumption there are some of the problem also that
this model carry: The model says that there are no tax or transaction costs, but this cannot be
possible in the investment that it doesn’t carry tax or transaction cost so this was the problem for
this model although this assumption may be saved from the more complicated versions of this
model. CAPM assume that the entire active and the potential shareholders who take part in the
day to day activity of the business will consider all the assets but will optimize on portfolio only.
But this assumption was properly contradict by the individuals shareholders in the company as
human have the habit to move safely, so for these kind of situation also they make multiple
portfolio each portfolio for every goal (Fama, & Macbeth, 1973). CAPM model assume that the
economic agent will optimize in the short –term of time, according to the fact the long term
investor will choose the long –term outlooks instead of the short term of investment as long term
investment are more risk free assets for the agent (Graham, & Harvey, 2001), The traditional
CAPM use historical data for predicting the future expected return or the expected value, but just
on the basis of the historical value, it may become hard to predict the future flow of the business.