1150 words - 5 pages

The Capital Asset Pricing Model

Introduction

The Capital Asset Pricing Model (CAPM) which builds on the portfolio theory was first stated by William Sharpe who was the Nobel Prizewinner and other theoreticians. This financial theory had a great impact on the practical of finance and business for more then forty year since it birth(Arnold, 2013, p269). After that it was developed by Lintner and other theoreticians in 1965(Black, Jeson, Scholes, 1972, p1). The CAPM is used to measure risk and the ties between variance of risk (market beta) and the expected rate of return (reward) (Fama & French, 2004). And it mainly deal with two problems, one is how to choose a portfolio, the other is to utilize diversification investment to reduce the risk. This essay is about the CAPM, it will begin by the fundamental feature of the CAPM , this will be followed by the description of the relationship between risk and return. Details on empirical evidence related to the CAPM are discussed in the later section. And at last it will discuss whether the model can be use in practice.

The relationship between risk and return

It is wildly accepted by the investors that the increasing of financial asset are accompanied by the rise of risk (Understanding Risk and Return, the CAPM,

and the Fama-French Three-Factor Model, n.d.). There are two kind of risk, one is unsystematic risk which is diversifiable, the other is systematic risk. The systemic risk which calculated as Beta (β), is the central tenet of CAPM that measures the a security related to the market (Capital Asset Pricing Model(CAPM), n.d.). The systemic risk is the only factor that can influence the expected rate of return on a share by the investor. The formula of the calculation of beta is: cov j R˜ , M ( R˜ ) 2 # M (R˜ ) = the “systematic” risk of the jth asset (Black, Jeson, Scholes, 1972, p2).

The fundamental feature of the capital asset pricing model

The basis of CAPM is the portfolio theory, and CAPM can be used to price a individual asset, or asset portfolios (Capital Asset Pricing Model, n.d.). The greatest contribution of CAPM is that through the introduction of yield to maturity and variance quantificat the reward and risk. The CAPM is a linear model which is defined as :

Required return on share = Risk-free rate of return +Risk premium

From the formular above, it is obvious that the bond of beta and returns is reported by a straight line, and the relation between the expected risk premiums on individual assets and their “systematic risk”. The relationship is: E(R˜ j) = E M (R˜ ) j (Black, Jeson, Scholes, 1972, p2).

Empirical evidence relating to the CAPM

Based on the fomular, it can be seem that the investment decision can be made by the corporate managers by calculating the require rate of return (Elton, et, al, 2011, p8), and if the Beta is high, the return will be high, but that just a theory, it did not have any practical significance, it need to be tested to be proved whether it could be...

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