Capital asset pricing model serves for decision making purposes relating to a portfolio of assets. The technique factors in the expected market rate of return, the risk free rate and the beta of the related asset. The CAPM model works on a number of assumptions. Two important assumptions of the CAPM model are that investors are rational and risk adverse and that the information flows perfectly to all investors. CAPM formula is the sum of the risk free rate and the product of risk premium and the beta. Beta is found by dividing the market covariance and risk free rates of return by the variance of the expected market return. CAPM model incorporates the effects or risks in the market. It distinguishes risk factors from other market factors and gives a framework for decision making. Although the assumptions it employs to not hold, CAPM serves as a convenient decision making model.
Securities and their Valuations
In the decision making processes, financial managers value the assets for purposes of investment when faced with a number of options in a portfolio of investments. One tool of measurement is the capital asset pricing model (CAPM). It basically incorporates the riskiness of the assets involved in the portfolio. It then ranks the asset in terms of the expected rates of return. Although the CAPM has its weaknesses and strengths, it offers a suitable decision making model that essentially incorporates risk as a factor to decision making.
Components of CAPM
CAPM consists of three main variables which determine the consequential outcome. They are: risk free return rate, expected market rate of return and beta. The three factors combine to give the expected return in a given capital asset. It is the expected return that would be compared to the required rate of return of the firm. For decision making purposes, the decision variables employ a comparison of the expected return of the capital asset against the required return of the firm. For the firm to accept and adopt an investment alternative, its expected market return should be greater than the firm’s required rate of return. Otherwise, the investment alternative is rejected. The following are the components of CAPM:
The risk free return rate
This refers to the return rate that is free of any risks in the markets. Usually, the rate used would be for a government security such as a treasury bill. This is because government securities have the lowest risks attached to them as compared to other securities in the market. The assumption usually is that the risk free rate of return gives the ideal set up that does not suffer any market risk.
Expected market return
Expected market return refers to the return on a market security that has incorporated related market risks. It gives the ideal situation that incorporates the market risk. It is the converse of the risk free rate. The expected market return, therefore, is arrived at after fully appreciating the risks in a particular financial market.
Beta refers to the sensitivity of the excess asset returns relative to the expected additional market returns. Beta illustrates the sensitivity of the returns. Sensitivity refers to changes in the variables as a consequence of changes in other variables. Beta is arrived at by dividing the covariance of the risk free return rate and the expected market return to the variance of the expected market return.
The difference of the expected market return and the market’s risk free return gives the risk premium. It is the risk premium that would be multiplied with the beta and the result added to the risk free return rate give the expected return on the capital asset. CAPM works on several assumptions. It would be noteworthy to note that the five assumptions. There are risk-free assets; the returns on assets are normally distributed; the rate of return is based on market beta alone; there is homogenous expectation about expected return and that all assets are perfectly divisible. CAPM is often criticized on the basis of these assumptions.
The formula of computing CAPM is a function of the three factors. In essence, CAPM is the risk free rate of return added to the product of beta and the given risk premium. The Capital Asset pricing model is calculated using the formula below:
Ri = Rf + B (Rm – Rf )
Ri = expected return of the capital asset.
Rf = risk free rate of interest usually treasury bills.
Rm = expected rate of market return
Bi = beta; this is the sensitivity of the expected excess asset returns to the expected market returns.
The CAPM model basically incorporates the riskiness of the assets involved in the portfolio. CAPM consists of three main variables which determine the consequential outcome. They are: risk free return rate, expected market rate of return and beta .CAPM has five main assumptions. There are risk-free assets; the returns on assets are normally distributed; the rate of return is based on market beta alone; there is homogenous expectation about expected return and that all assets are perfectly divisible. CAPM is often criticized on the basis of these assumptions.
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Kürschner, M. (2008). Limitations of the Capital Asset Pricing Model (CAPM): Criticism and New Developments. New York: GRIN Verlag.
Levy, H. (2011). The Capital Asset Pricing Model in the 21st Century: Analytical, Empirical, and Behavioral Perspectives. Cambrigde: Cambridge University Press.
Shim, J. K., & Siegel, J. G. (2008). Financial Management. New York: Barron's Educational Series.