capital asset pricing model

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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...

... middle of paper ...

...04). The Capital Asset Pricing Model: Theory and Evidence. The Journal of Economic and Perspectives, 18(3), 25-46

Fama, E. F. , Lawrence F, Michael C. Jensen, & Richard R. 1969. "The Adjustment of Stock Prices to New Information." International Economic Review, 10 (1), 1-21. Available from the Social Science Research Network eLibrary at: http://papers.ssrn.com/Abstract=321524. Reprinted in Investment

Horne, J. C. V. (1980). An Application of the Capital Asset Pricing Model to Divisional Required Returns. Financial Management, 9(1), 14-19

Understanding Risk and Return, the CAPM, and the Fama-French Three-Factor Model. (N.d.). Retrieved from: http://www.portfoliosolutions.com/pdfs/FF_3_Factor_Tucks.pdf

Roll, R. (1977). A critique of the Asset Pricing Theory’s test: Part 1: ON past and potential testability of the theory. Journal of Financial Economics, 129-176

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