Introduction To Asset Pricing And Investor Behavior Essay

Introduction To Asset Pricing And Investor Behavior Essay

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Uses and Iimitations of the CAPM

Graham and Harvey surveyed the CFOs of 392 U.S. firms and found that when estimating the capital of assets,73.5% of respondents use the CAPM.( Graham, J. R., and C. R. Harvey,2001) It is a model which uses simple formula to evaluate asset pricing and investor behavior. This model is absolutely the method with most investors used, but many financial experts raise an objection to the veracity of this method in the recent years. Later in the main body of the essay will discuss these questions. In the first part of the essay will introduce the CAPM and the main factor of this method. Secondly, is the discussion of the uses and limits of the CAPM while evaluating the potential investment of a firm 's share. After that is the adverse and favorable way of the CAPM as a resource of discount rate. The last paragraph is the conclusion that rating the merits and demerits of the CAPM in the investment.

Main body
Capital asset pricing model (CAPM) first provide the coherent framework for answering the relationship of expected return and the risk of investments and how equilibrium price come out.(Perold, A. F. ,2004) The initial goal of CAPM is to assess the risky assets such as stock. And the stock value is mostly according to the degree of risk that the held shares might get the return. These properties are similar to venture capital and both of them discounted future earnings in accordance with risk premium. So that, CAPM can used to determine the discount rate of the venture investment project at the same time. Although the model does not describe the current world well, it still gives investors a prediction of their future behavior.
For investors, CAPM is a method to prescribe the expected r...

... middle of paper ...

...ts can reasonably be excluded from the market portfolio, and data availability substantially limits the assets that are included. As a result, tests of the CAPM are forced to use proxies for the market portfolio, in effect testing whether the proxies are on the minimum variance frontier. (Fama, E. F., & French, K. R. ,2004)
3. The present price trend is not a good guide for future tendency of price. Sometimes, some Technology stocks do not exist that long to estimate the future trend. Furthermore, the beta focus on single stock tends to change direction as time goes by, which makes it unauthentic in long-term horizon.

CAPM is not a perfect model, but it is correct from analysis the problem. It provides a model which can evaluate the degree of risk and this can help investors to make the decision whether it is worth to face the risk for its future return.

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