This assignment is about the Capital Asset Pricing Model. A concept which came into use after the famous noble laureate Mr. William Sharpe introduced it in his book called “Portfolio Theory of Financial Markets”. Capital Asset Pricing Model is a model that tells an investor about the risk on particular securities before investing the amount of money. Now whom wont love a concept or an application that suggests or tells us the rate of risk and the rate of expected return on the investment that we are going to make, hence capital asset pricing model is the one that provides good theoretical results which is capable of influencing the decision of the investor in case of investments (Milton, 2012). If we now talk in simpler words about CAPM then it goes like this, ‘CAPM is nothing but a theoretical model with a formula that if applied on an investment plan generates results. Now these results can be in the favor of the investor or against the investor. It is then the investor who has to decide whether to go with the results or not. In capital market there are no certainties, you can’t even predict what can happen next, this uncertain behavior of market restricted many investors to invest their hard earned money. However the big players of financial markets couldn’t hold this situation and they were looking for some means of bringing in the investors, so that they can get some money, so what brought in the confidence of the investors into the financial market was the birth of the capital asset pricing model. This cannot be said that, ‘it is only CAPM that brought in the confidence of the investors, long before the birth of CAPM, investors were still investing with big risks, however the birth of CAPM just brought in the wave of confidence in the investors and even the smallest of the investors started investing their money (Mizrach, 2014).
Now here in this section, we are going to discuss about what capital asset pricing model is all about in very much detail. If we talk about what investors does, then the clear answer would be, he is a person who invests his or others money into different securities of the market. Now it is the responsibility of the investor to invest the money in such a way that it gives more returns and less risk on the investments of the people (Hidek, 2011). However it needs to be understood by us that more the risk more will be the rate of return and lesser the risk low will be the rate of return on the investment made by the investor. CAPM capital asset pricing model has played an significant role in the literature of finance (Giovanis, 2010). The (CAPM) model helps in understanding the market concept price risk for evaluating the threat for a portfolio. The CAPM manifest the balance returns rates for the entire menaced portfolio. The theory of CAPM guides to assimilate the fluctuation of market according to CAPM the market return is not constant. Moreover the progress of CAPM theory is based on many assumptions (Bejjani, 2009).
Hence in capital market, no matter how hard you try to scatter your investments, there will always be the scope of risk attached to it (Ang, 2006). Suppose you as an investor have invested into 20 kinds of different governmental and non-governmental securities and you expect that at-least 10 out of 20 securities, will give you expected returns with no risk, then it is your mis-conception only (Banz, 2000). In financial market there is nothing which is risk free. Yes, you can make investments with government banks in their saving accounts, where you will get a proper rate of return but it will be quite low, if you compare it with the rate of return of the financial market. The only benefit you will get on your money with the government bonds or government banks is that your money is safe and will grow on a very low rate.
Now we are going to discuss, how capital asset pricing model came into existence. As mentioned in the introduction paragraph, the concept of capital asset pricing model was brought into existence by the financial economist called “William Sharpe” in the year 1970. He brought this concept in one of his book. He told that capital asset pricing model will theoretically provide all the answers to the questions of an investor. In his model of capital asset pricing model, he mentioned that the expected rate of return, the return which is risk free, the risk and the risk of the market can be easily find out and on these basis the investor can actually make investments that yields him more and more returns with lesser risks. However low risk and high returns are just a myth (Fama, 2012). There is nothing like that in financial market till date. No investor, economist, financial analyst has found any measure or means to bring the risk to the minimum and the return to the maximum. Now if we talk about, how capital asset pricing model works, then first of all we need to understand that the capital asset pricing model is nothing but a formula that if correctly applied on an investment will give you a close or an accurate result. Now this formula with a diagram is as under:
Ra = Rrf + [Ba x (Rm – Rrf)]
Where:
Ra= Stands for the expected return on security
Rrf= Risk Free Return
Ba= Beta of the Security
Rm= Expected return on the security
The CAPM model is used by various investors to allocate the risk on rate of returns. The model can use for evaluating the cost of equity and it user the beta formula. The CAPM model also helps in calculating the discount rate to which is used for investment appraisal. The capital asset pricing model is considered as an important model in the field of financial management. It has been advice for much financial operation. Besides this, CAPM is criticized for unrealistic approach. The reason for criticism was the assumption on which it is based before actually using CAPM or applying CAPM for a financial operation, one must be aware of the assumption of CAPM on which it world and the reasons for the criticism.
Now as shown in the above image, the risk free return is the only return that one can earn from the government bonds or securities or by depositing money in the banks. However the scope of such savings or investments is very limited. You can earn a very limited amount of money by investing almost all of your money. However if we talk about the financial market, where the risks is much more but the rate of returns are not slightly but very high than the government securities or bonds. People desiring of earning large sums never go to the banks they direct their investments into the financial market and they make 100 from their 10.
In order to make the capital asset pricing model capable of battling with the modern time issues of financial market, so that the investors can use the capital asset pricing model with having no doubt in their mind about its ability of providing accurate results (Fama, 2006). The recent developments that have been made in capital asset pricing model are as under:
Capital asset pricing model has its own benefits and drawback. First we will discuss about the disadvantages of CAPM. CAPM has numerous limitation which needs to accessed before application of the model
It is not that the CAPM theory is only based on limitation it has same good benefits as well
Conclusion
After going through all the facts and information about the capital asset pricing model, a detailed conclusion has been provided here. Capital asset pricing model is no doubt earning a good name amongst the economists or the investors. It is useful too while calculating the expected rate of returns on riskier investments. The recent developments in the capital asset pricing model shows that it is now gaining attention and acceptance at a wide scale, however it is still to be loved by everyone. Early in the year 1980, the capital asset pricing model received much criticism and it was tested by few economists. The outcome of applying it on the investments didn’t brought out any noticeable result, which further proved that the capital asset pricing model does not provides any accurate result. However, here the thing worth mentioning is that most of the economists find capital asset pricing model as a useful base for investments, though it does not provide any full proof results but it does provides some guidelines for the investments that proves out to be useful for the investor. All in all the final conclusion about capital asset pricing model is that, despite of having much criticism, the capital asset pricing model provides not an accurate but a better understanding and results about the returns and risk of an investment and it can be used but keeping certain things in mind.
Ang, A..R.J.H.Y.X.a.X.Z., 2006. The cross section volatility and Expected Returns. The Journal of Finance, 61(1), pp.259 – 299.
Banz, R., 2000. The Relation between Return and Market Values of Common Stock. Journal of Financial Economics, 9, pp.3-18.
Bejjani, L., 2009. Financial Risk Management: Testing the CAPM of Citigroup Stocks. New York: American University of Beirut, Department of Economics, 2009.
Fama, E., 2004. The Capital Asset Pricing Model: Theory and Evidence. JOURNAL OF ECONOMIC PERSPECTIVES, 18(3), pp.25-26.
Fama, E.F.a.K.R.F., 2006. The value premium of CAPM. The Journal of Finance, 61(5), pp.2163 – 2185.
Fama, E.F.a.K.R.F., 2012. Size, Value, and Momentum in International Stock Returns. Journal of Financial Economics, 105(3), pp., 457 – 472.
Giovanis, E., 2010. Application of Capital Asset Pricing (CAPM) and Arbitrage Pricing. Germany.
Hidek, I.i., 2011. Equilibrium of Asset Pricing Model.
Milton, F., 2012. CAPM Introduction. New York: Cengage Publications.
Mizrach, B., 2014. Testing the CAPM & 25 Portfolios.
Mona., E., 2016. The Capital Asset Pricing Model: An Overview of the Theory. International Journal of Economics and Finance , 7(1)
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