Capital Asset Pricing Model Essay

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CAPM is standing for Capital Asset Pricing Model which helps investors to calculate investment risk and also evaluate portfolio’s rate of return. It is based on the Markowit’s mean-variance theory. Capital asset pricing model is an equilibrium model which can be used to explain the relationship between the systematic risk and the expected return of a portfolio. The capital asset includes bond, stock, securities and etc. This essay will be divided into three parts. First of all, the capital asset pricing model will be fully introduced and the components of CAPM will also be explained. In addition, it is going to illustrate the security market line(SML) which indicates the relationship between risk and expected return by graph. Secondly, the …show more content…

The graph shows when beta coefficient is 0, the expected return is the risk-free rate(3.5). With a beta coefficient of 1, the expected return is 8. It also has a beta of 2 and the expected return is 12.5. Clearly, the higher the beta, the expected rate of return is also relatively high. This can explain that the investors will only take the risk when they can earn more.

Applications of the CAPM
There are some advantages of CAPM. First of all, the CAPM is quite simple and clear. Secondly, it widely used because of it is practicable. Investors can evaluate and choose stocks by using CAPM through non-diversification risk rather than the entire risk which is including systematic and unsystematic risk(Arnold, 2013). Thirdly, the CAPM is an instrument for investors to choose the best stock. In addition, it helps to illustrate the positive relationship between risk and return and it is good for identifying mispriced shares and then it is an investor behaviour guideline(Nel,2011).

Estimated the cost of equity
A company needs to calculate the cost of equity first in order to estimate the weighted-average cost of capital(WACC). According to Brealey, Myers and Allen(2011), most generous financial companies calculate the cost of equity by using the CAPM. It is the formula which is use for calculating the weighted average cost of …show more content…

In other words, the expected return of A is higher than the required return at the same risk level. In addition, this portfolio A is underpricing and it is worth to buy. Portfolio B is overpricing and it needs to sell. It is because at the same beta coefficient the expected return is lower than the SML. If investors can get a higher return for the same risk level and they will not choose the lower one. To conclude, investors can use CAPM and SML to identify the share price and choose whether sell it or not.

Limitations of the CAPM and Three factor model
Although CAPM is widely used in asset pricing, there are some limitations of the CAPM. Firstly, the CAPM only think about beta and ignore some risk factors. Secondly, the ideal assumption is hard to achieve. In other words, the market is not perfect which cannot fulfill all the basic premise of the CAPM. Thirdly, it is not easy to estimate the beta coefficient. In addition, beta is estimated by historic data which may change in the future, investors only care about the future price variability so the beta sometimes can be regarded as

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