1729 words - 7 pages

The Capital Asset Pricing Model (CAPM)

Introduction

In almost every economics textbook (Ben and Robert, 2001), economists

tend to argue: everything’s market price is determined by consumers’

demand and supply in the market, the intersection of which gives us

the long-term concept of ‘market equilibrium’. Although it sounds

straightforward, it is anything but easy in practice, especially when

the assets (like common stock) you are measuring associated with risk

and future uncertainties. Fortunately, economists and financial

analysts have developed plenty of theories to help us explain how the

risk for market assets can be appropriately measured in our life.

Capital Asset Pricing Model (‘CAPM’) is one of the most influential

and applicable models, which give good explanations and predictions of

‘market price for risk’. This essay is going to look at what the CAPM

really is, how it is derived and used, and will also see some

limitations of applying it in practice.

Assumptions

First of all, we have to make some assumptions here, as the CAPM is

developed in a hypothetical world, as written in the theory of

business finance (Archer and Ambrosio, 1970):

* Investors are risk-averse individuals who maximize the expected

utility of their end-period wealth.

* Investors are price takers and have homogeneous expectations about

asset returns that have a joint normal distribution.

* There exists a risk-free asset such that investors may borrow or

lend unlimited amounts at the risk free rate.

* The quantities of assets are fixed. Also, all assets are

marketable and perfectly divisible.

* Asset markets are frictionless and information is costless and

simultaneously available to all investors.

* There are no market imperfections.

Although not all these assumptions conform to reality, they are

simplifications that permit the development of the CAPM.

Derivation of the CAPM

According to Financial theory and corporate policy (Copeland and

Weston, 1946), the CAPM is based on Harry Markowitz’s early portfolio

theory (1952) which showed how an investor can reduce the standard

deviation of portfolio returns by choosing stocks that do not move

exactly together (Brealey and Myers, 2003). Thereafter, William Sharpe

(1963) stimulated all possible combinations of stocks in the market,

getting a graph similar to Figure 1a below. Because of the one of the

golden rules in finance: ‘investors prefer higher return but low risk

(deviation)’, there must be some efficient portfolios that best

satisfies different investors’ preferences.

Here in figure 1b, all the points along the ‘efficient curve’ provide

investors with best return given certain risk level. It is a matter of

different preferences which are up to individuals’ different utility

function (Frank, 2003) and determine which to choose for different

investors. However, if an alternative investment opportunity is

introduced where investors...

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