Understanding the Capital Asset Pricing Model (CAPM)

Running head: STRATEGIC FINANCE
Strategic Finance
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STRATEGIC FINANCE
Table of Contents
INTRODUCTION...........................................................................................................................2
DEVELOPMENT OF CAPM MODEL..........................................................................................2
ASSUMPTIONS OF CAPM MODEL............................................................................................3
ADVANTAGES OF THE CAPM...................................................................................................5
DISADVANTAGES OF THE CAPM............................................................................................5
LIMITATIONS OF CAPM MODEL..............................................................................................6
CONCLUSION................................................................................................................................6
REFERENCES................................................................................................................................8

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STRATEGIC FINANCE
INTRODUCTION
Equity markets are considered to be high risk markets which are managed by the activities of the
investors and fund managers. In this type of market there are possibilities of high profits and risk
of incurring heavy losses. The fund managers and investors take aid of various tools for
calculating the risk and return of their investments.
The finance industry makes extensive use of Capital Asset Pricing Model. The model was
founded by Harry Markowitz in the year 1952. This framework was further developed by
economist Jack Treynor, John Lintner, Jan Mossin and William Sharpe. This is a mathematical
model which helps in describing the relationship between the investors expected returns and the
risk associated with capital asset. Securities, stocks and bonds are included in the capital stock.
As per CAPM theory, the expected return related to specific portfolio or security is same as the
rate related to security without risk and risk premium. It is structured for calculating the price of
high risk securities. Investment should not be done if the portfolio or stock does not meet or
surpass the expected return (Bai et al., 2015).
DEVELOPMENT OF CAPM MODEL
CAPM model has been based on the theory of portfolio management which has been created by
Harry Markowitz, as per Harry portfolio should have expected rate and returns. The expected
returns relates to the expected return on securities while the risk relates to the risk associated
with individual components. If the relevancy of return and risk associated to specific conditions
are considered it can be seen that more returns are gained on higher risk while less returns are
earned on lower risks. Mean variable analysis is the process in which the multidimensional and
complex problem of portfolio choice related to large quantity of diverse assets is reduced to a
two dimensional problem (Bai et al., 2015).
The risk associated with expected return on asset is divided in to two categories by using CAPM
model: Systematic risk, Unsystematic risk. Systematic risk is the basic risk which exists in the
stock market while the unsystematic risk is industry specific threat in all kinds of investment.
The CAPM model states the relationship between expected returns of an investment and the risk
associated with it for determining the investment price. This model demonstrates that risks can