This report discusses about the strengths and weaknesses two types of asset pricing theory - Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT). The CAPM model shows the relationship between the fair expected returns and the systematic risk of a portfolio. Figure 1 shows the formula of CAPM.
The APT model also shows the relationship between the fair expected returns and risk in line with the law of one price, taking into account both systematic and unsystematic risks. Figure 2 shows the APT formula.
CAPM includes systematic risks in its calculations. Systematic risks are risks that are caused by macroeconomic factors like war, recession, inflation, interest rates, etc. Systematic risks are not included in other returns calculation models like the Dividend Discount Model. It is necessary for an investor to recognise the volatility of his stock due to the systematic risk compared to the market returns, in order to demand for an appropriate return from that stock. The trade-off between systematic r...
Need Writing Help?
Get feedback on grammar, clarity, concision and logic instantly.Check your paper »
- In the following essay I will be comparing and contrasting the effectives of capital asset pricing model (CAPM), Arbitrage Pricing Theory, and the Fama-French three factor model when estimating the cost of capital and explaining performance of investment portfolios. Todays widely used CAPM model was originally developed by Sharpe (1964) in order to explain how capital markets set share prices. (Pike and Neale) However, was then developed by others such as Harry Markowitz, John Linter and Jack Treynor.... [tags: Capital asset pricing model, Financial markets]
1608 words (4.6 pages)
- Comparing and Contrasting Pricing Model In this paper I will discuss the growth and development of the Capital Asset pricing Model (CAPM).I will also identify and analyze the different applications to the CAPM. I will try and illustrate how the model can be used to form expected return and valuation measures. These illustrations will be informed by examples from stock options and restricted stock. Finally I will conduct a comparative analysis of the potential outcomes associated and comparative benefits and risks for using the CAPM versus the Arbitrage pricing theory (APT).... [tags: economic/financial analysis]
1949 words (5.6 pages)
- 1. Please discuss and explain the CAPM and the SML. Provide a numerical example for the CAPM. Total risk is the relevant measure of risk, do you agree. The security market line (SML) is a line that charts the efficient, or market, risk versus return of the entire market at a specific time and demonstrates all risky marketable securities. The SML basically diagrams the outcomes from the capital asset pricing model (CAPM) recipe. The x-hub speaks to the risk (beta), and the y-hub speaks to the normal return.... [tags: Capital asset pricing model]
734 words (2.1 pages)
- Security market line (SML) is a line on a chart representing the capital asset pricing model (CAPM). The security market line plots risk versus expected return of the market. The security market line is a useful tool in determining the relationship between risk and return for individual securities. If a security plots the security market line, it indicates a higher expected return for a given level of risk than the market. The security market line shows a positive linear relationship between returns and systematic risk as measured by beta (Boundless, 2016, para.2).... [tags: Capital asset pricing model, Financial markets]
933 words (2.7 pages)
- There are a lot of items that go into buying and investing in a company. One of the hardest decisions for a shareholder is deciding if the investment is going to be profitable. Once a shareholder decides to buy or invest in an organization the next step would be deciding how much to pay or invest. Another hard decision is if the investment that was made goes bad can you get out of this obligation. Throughout the course of the paper I will illustrate some of the items that assist with this decision process.... [tags: Finance, Weighted average cost of capital]
825 words (2.4 pages)
- CAPM model requir the beta, risk-free rate and the expected market risk premium to calculate expected rate of return of the security. From the graph above, it can be seen that, CAPM model has a direct relationship with the capital market line, which is a straight line connecting risk-free assets with the market portfolio. If the market equilibrium exists, all asset prices will be automatically adjusted until it all can be accepted by the investor. In the CAPM formula, “r” is expected return on sercurity, “”rf ” is risk-free rate, “rm” is the return from the market.... [tags: Capital asset pricing model, Financial markets]
978 words (2.8 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.... [tags: Business Management Studies]
1862 words (5.3 pages)
- The capital asset pricing model (CAPM) is a mathematical model that offers an explanation about the relationship between investment risk and return. By dividing the covariance of an asset's return by the variance of the market, an asset value can be determined. To ascertain the risk level of a particular asset, the market is evaluated as a whole. Unlike the DCF model, the time value of money is not considered. This model assumes the investors understands the risk involved and trades without cost.... [tags: Finance Analysis]
1006 words (2.9 pages)
- The research article discusses two approaches, one method is Islamic financing and other is the conventional capital asset pricing model (CAPM). Using the direct Musharakah, Islamic financing method is applied against the conventional financing method by comparing each other. Comparing the two approaches has drawn several findings; it is found that the beta-risk is lower on investments, which are based on the partnership of Islamic financing as compared to the conventional market. The risk is on the share of the lenders and others but not on the risk-return.... [tags: Islamic Finance Essays]
2951 words (8.4 pages)
- A lot of regulation is concerned with a firm’s rate of return, and so early practitioners advocated the use of the CAPM as a tool for regulators in setting appropriate rates that allow firms within regulated industries (such as utilities) to earn a rate of return that is commensurate for firms with a similar degree of riskiness. The application of the CAPM has been demonstrated in two different papers both published in 2012. The first by Muradoglu and Sivaprasad (2012) uses the CAPM formula to look at gearing and its effects on stock returns to measurements of firm performance, as stock returns are forward-looking and they integrate expectations of investors of the future value of the firm.... [tags: Weighted average cost of capital, Finance]
1249 words (3.6 pages)