Capital Asset Pricing Model

Finance is very essential sector in all kind of organization to be successful. It contains many financial theories which have been developed throw the years depends on special circumstances such as time, money, demand and supply. One of the important financial theories' is the capital asset pricing model which gives the investor individuals or companies the ability to be more realistic in their investments by taking market risk into consideration. This paper will explain what the capital asset pricing model is, then it will descript the CAPM theoretical underpinning and it will conclude with evaluating the CAPM.

First of all, to have a good explanation of the theory, the historical background must be explained. The capital asset pricing model is a development theory of Markowitz's portfolio theory. Markowitz's portfolio theory was found in 1952 and awarded Nobel Prize in economics in 1990 (Watson & Head, 2006). The theory is giving the investors the ability to avoid desultory risk by choosing variety of portfolios which contain different number of shears. Markowitz's first point is to build the envelope curve which is giving the maximum return or minimum risk for a giving stage of return, this shows the investors a group of portfolio available choices when investing in a set of risky assets and it is advising the investors to invest in particular portfolio (Watson & Head, 2006).

However the portfolio theory has many problems with the practical application such as: the ability of investors to borrow at risk-free rate it is unrealistic, the theory has a problem in identifying the market portfolio and after identifying the make-up of the market portfolio it is expensive to be built because of the transaction cost which is unaf...

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...is the security market line which is the liner relation between risks and returns (Watson & Head, 2006). In the security market line investors want bonus added to what they receive on a risk-free investments to make them invest in something risky such as shears (Arnold, 2008). That makes the security market line important for the investors because is identifying the risk in the market as a systematic risk (Arnold, 2008), which needs to be compared with risk and return of the market and with the risk-free rate of return. This comparison is necessary to calculate tow things which are: the demanded return for the security and the fair price (Watson & Head, 2006)

Works Cited

Watson, D.W. & A.Head (2006), corporate finance: principles and practice Essex: Pearson Educational Limited.

Arnold, G (2008) corporate financial management Essex: Pearson Educational Limited.