Free Economics Dissertations - An Analysis Of The Capital Asset Pricing Model And To What Extent Has It
An analysis of the Capital Asset Pricing Model and to what extent has it contributed to finance and portfolio management.
Introduction
The following paper provides a detailed analysis of the Capital Asset Pricing Model (CAPM) which was developed by William Sharpe. Following the development of portfolio theory by Markowitz, two major theories were put forth that employed the theory to derive a model for valuation of risky assets; they were namely the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT). Reilly and Brown (2000) defined Capital Asset Pricing Model (CAPM) as a model which indicated what the expected or required rates of return on risky assets should be. This model was a transition from the capital market line theory; it was vital to understand the transition because it helped to understand how to value an asset by providing an appropriate discount rate to use in the valuation model. Capital Asset Pricing Model has been widely used in the finance literature.
CAPM is derived from portfolio theory which applies statistical techniques to investment portfolio selection. The model uses the concept of capital market line to explain the required rates of return on risky assets. The following diagram illustrates the concept, and also indicates three different levels of return, namely:
Rm: the return on market portfolio
RI: the return that investor needs
RF: the risk free rate of return
In the above diagram systematic risk indicates the degree of risk in an investment after specific risk has been diversified out. This takes place by purchasing a diversified portfolio of investments.
The CAPM has been widely applied to all kinds of financial instruments, including futures contracts. CAPM measures the systematic risk of an asset by ?, and ? is usually estimated from a regression equation. The following equation represents the basic relationship of the CAPM:
E (Rj) = r + ?j [E (Rm) r]
where,
r = is the risk free interest rate
E (Rj) = is the expected return on asset j
E (Rm) = expected return on the market portfolio
?j = is the beta of the asset k
The key assumptions of CAPM are as follows:
All investors have rational expectations
All investors are risk averse
There are no arbitrage opportunities
Returns are normally distributed
There are fixed quantity of assets
Perfect capital markets
Risk free rates exist with limitless borrowing capacity and universal access.
Investors need only to know the expected returns, the variances, and the covariance of returns to determine which portfolios are optimal for them.
Investors have identical views about risky assets’ mean returns, variances of returns, and correlations
Investors can buy and sell assets in any quantity without affecting price, and all assets are marketable and can be traded.
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