Capital Asset Pricing Model Answers Assessment Answer

Answer:

Introduction:

The Capital Asset Pricing Model (CAPM) is a model which is used to describe the relationship between the risks and returns for assets such as stocks. Therefore in theoretical terms it enables to assess the required rate of return from a particular asset. It basically helps the investors to analyse and assess the profits they may gain from assets such as securities and whether a particular asset should form a part of their diversified portfolio or should be sold off from their portfolio. Therefore the said model enables the investors to take more informed decision with regards the assets which are very sensitive to the market movement and these risks cannot be diversified also.

What is Capital Asset Pricing Model

Capital Asset Pricing Model (CAPM ) was introduced so as to enable determination of prices of individual stocks and a portfolio as a whole. It was formulated by Jack Treynor in the year 1961 & 1962, William F. Sharpe in the year 1964, John Lintner in the year 1965 and Jan Mossin in the year 1966. Thus it was introduced by four eminent economists separately. One more version of CAPM was developed named Black CAPM by Fischer Black in the year 1972.


lign: justify;">The CAPM is required by a portfolio manager who helps the investors decide about their portfolio. His main work is calculation of the equity capital to a company. Thus the said method enables quantification of the expected perils and thus enabling conversion of the possible risks to expected returns on equity. The theory has various assumptions to be taken into consideration while calculating the expected return from the risks that the securities possess. Firstly it assumes that the financial markets is full of investors who are well informed, highly educated and are prudent buyers and sellers. Second assumption states that the investors are very much concerned about their money and expect to earn a premium for the extra risks they assume while investing(Fama, & French, 2004). Thirdly all the investors are considered to be moving ahead towards the same period for planning their investments. Fourthly there are no taxes or concessions or commissions applicable. Lastly it is assumed that there is just one risk free rate and the investors borrow or lend in that rate only (Mullins, 1982). 


The formulae for calculating the return from a asset from the expected risks is :

r* = kRF + b(kM - kRF)

r*= Required rate of return

kRF= Risk free rate

kM= Average market return

b= Beta Coefficient of security (Wogner, 2015)

The said formula is also known as Security Market Line Formula.

Relationship Between Security Market Line (Sml) And Capital Market Line (Cml)

The Security Market Line is a line which correlates the return an investment fetches in relation to the risks attached. The measurement used for risk by the SML is beta. The SML diagram below clearly indicates that the line begins with nil risk attached to an investment and as the line is moving diagonally upwards the risk attached to an investment increases with an increase in the risk also. Thus risk and return are directly proportionate to each other. Therefore an investor with a low appetite for risk would prefer investing at the beginning of the SML and those with a higher risk appetite would prefer to invest at the middle or above that of the SML.

The Capital Market Line (CML) is a line which portrays the rate of return of an efficient investment portfolio after taking into account the level of risks attached for a market portfolio and the risk free rate of return. Therefore this line basically speaks about not only the risks attached to a particular stock i.e. unsystematic risks but also how the risks affect the functioning of the overall market i.e. systematic risk. Thus whenever an investor build up his investment portfolio his basic idea lies to gain the maximum possible return with minimum possible risk attached. But the said idea situation does not exist always because of the attached volatility and unexpected performances and movements of the stocks, therefore increased risk can also lead to magnification of losses. Therefore the CML can be described diagrammatically as under:

From the above two definitions it is clear that there exists a relationship between the SML and CML in a Capital Asset Pricing Model. Both the concepts are related to the extend that many a times the SML is said to be a part of the CML while calculating the risks associated with securities. The CML connotes the risk and the return for the entire portfolio of stocks whereas the SML reflects the risk and returns associated with individual securities which form a part of the overall portfolio. The measurement basis of risk is however not same. The CML uses the standard deviation and the SML uses beta. Therefore the capital market line focuses mainly on the performance of the overall portfolio whereas the SML’s focus is narrowed down to only individual securities.  

Advantanges of Capm

The Capital Asset Pricing Model theory has various advantages and uses that enables the investors to decide upon which securities to buy and how to build up a healthy and a profitable portfolio. They are:

  1. The calculations offered by this model is the simplest and stress tested which provides a wide array of outcomes. This in turn builds confidence amongst the investors to invest in a healthy portfolio.
  2. Presence of a diversified portfolio helps to eradicate the unsystematic risk.
  3. This is the only model which takes into account the systematic risk. It is important to consider the said risk is an unforeseen risk which should not be neglected or ignored and should form a part of the risk assessment theory. Thus this method is considered to be the most reliable amongst all as it enables comparison of the company’s performance with regards the market performance as whole (Sigman 2005).
  4. Lastly the said method is useful for appraisal of the investment portfolio as a whole as the discount rates offered by the said model is superior than those offered by other models. Due to this it establishes a strong linkage between return an investor expects from his investment and the systematic risk attached to the investment. 

Disadvantanges of Capm

However, the said model has got criticisms also due to some disadvantages attached to it. The same are as follows:

  1. The said model does not consider the volatile nature of securities and uses a commonly accepted risk free rate on short term government securities without factoring in the changes that place in the yield on a daily basis.
  2. The assumptions basis which the said model stands is unrealistic. Such as finding of a security which is free from all the risks is very difficult in today’s scenario. The next incorrect assumption is that the lending and borrowing rates are same which is highly impossible. Thus in such situations CAPM may fail to capture the risk of investment with the help of beta (Lee, & Su, 2014).
  3. Beta is used to measure basis the past information. Analysis has proved that the beta of individual assets is unstable thus the past data are not strong indicators of the risk that the securities would pose in the future. 

Alternative Models

The CAPM model is highly regarded and accepted world-wide, but there are other methods also used to determine the return against the risks attached to investments. Such as the Gordon DDM (Dividend Discount Model), Multi-Beta Models and Market Price Based model. These methods offer better methodologies of measuring risks and returns of the investments.

  1. Gordon DDM or the Gordon – Shapiro Model: As per the said model the price of the stock is determined by taking out the net present value (NPV) of the future dividends per share that is likely to accelerate at a constant rate and that the growth rate will remain unaltered. Thus this model cannot be used where the dividend of the companies are erratic in nature or where the companies do not pay dividend only (Damodaran, 2015).
  2. Multi-Beta Model: Two alternatives fall under the Multi-Beta Models. The Arbitrage Pricing Model which is similar to the conservative portfolio theory but unlike the CAPM theory it takes into consideration multiple sources of market risk and each risk as a separate beta estimated to it.

The second alternative to it is The Multifactor Model which uses the past information of the stocks in question and relates it to the specific macro economic variables and thus assigns beta to the individual companies against these macro economic variables (Krause, 2001).

  1. Market Price Based Model: There exists instability in the estimation of Beta which is highly volatile in nature. One of the alternative is to let go of the correlation fully and then estimate the price of stock by dividing the standard deviation with the average of standard deviation across all stocks. This method is a more stable method than the CAPM which uses Beta. 

Conclusion

Thus on a concluding note it is clear that CAPM is a very age old model which investors and the portfolio managers have been relying upon. Yet the same has some advantages and disadvantages to it which cannot be ignored. Being the most tried and stress tested model economists prefer it even though it is based on assumptions which may seem to be unrealistic. As per my recommendation although various other refined models have come up yet the CAPM dominates. According to me a portfolio manager should use Capital Asset Pricing Model and over and above the same he could use other methods as well. The alternate methods are also acceptable but no model is full proof each have their own pluses and minuses which should be considered while analysing a portfolio.

References:

Damodaran, A., (2015), The Dividend Discount Model, Available at https://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/ddm.pdf (Accessed 08th September 2016)

Fama, E.F., & French, K.R., (2004), The capital Asset Pricing Model: Theory and Evidence, Journal of Economic Perspectives, vol. 18, no. 3, pp. 25-46

Jylha, P., (2014), Margin Constraints and the Security Market Line, Imperial College Business School, Available at https://www.cbs.dk/files/cbs.dk/paper_petrijylha.pdf (Accessed 08th September 2016)

Krause, A., (2001), An Overview of Asset Pricing Models, University of Bath School of Management, Available at https://people.bath.ac.uk/mnsak/Research/Asset_pricing.pdf (Accessed 08th September 2016)

Lee, M.C., & Su, L.E., (2014), Capital Market Line Based on Efficient Frontier of Portfolio with Borrowing and Lending Rate, Universal Journal of Accounting and Finance, vol. 2, no.4, pp. 69-76

Mullins, D.W., (1982), Does the Capital Asset Pricing Model Work?, Available at https://hbr.org/1982/01/does-the-capital-asset-pricing-model-work (Accessed 08th September 2016)

Sigman K., (2005), Capital Asset Pricing Model (CAPM), Available at https://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-CAPM.pdf (Accessed 08th September 2016)

Wogner, J., (2015), Capital Asset Pricing Model (CAPM): Definition, formula, Advantages and Example, Available at https://study.com/academy/lesson/capital-asset-pricing-model-capm-definition-formula-advantages-example.html (Accessed 08th September 2016)

DOWNLOAD SAMPLE DOCUMENT NOW



Upload Document Document Unser Evaluion Get Money Into Your Wallet



Cite This work.

To export a reference to this article please select a referencing stye below.

Assignment Hippo (2022) . Retrive from https://www.assignmenthippo.com/sample-assignment/capital-asset-pricing-model-answers-assessment-answer

"." Assignment Hippo ,2022, https://www.assignmenthippo.com/sample-assignment/capital-asset-pricing-model-answers-assessment-answer

Assignment Hippo (2022) . Available from: https://www.assignmenthippo.com/sample-assignment/capital-asset-pricing-model-answers-assessment-answer

[Accessed 29/09/2022].

Assignment Hippo . ''(Assignment Hippo,2022) https://www.assignmenthippo.com/sample-assignment/capital-asset-pricing-model-answers-assessment-answer accessed 29/09/2022.


Buy Capital Asset Pricing Model Answers Assessment Answers Online

Talk to our expert to get the help with Capital Asset Pricing Model Answers Assessment Answers from Assignment Hippo Experts to complete your assessment on time and boost your grades now

The main aim/motive of the finance assignment help services is to get connect with a greater number of students, and effectively help, and support them in getting completing their assignments the students also get find this a wonderful opportunity where they could effectively learn more about their topics, as the experts also have the best team members with them in which all the members effectively support each other to get complete their diploma assignment help Australia. They complete the assessments of the students in an appropriate manner and deliver them back to the students before the due date of the assignment so that the students could timely submit this, and can score higher marks. The experts of the assignment help services at www.assignmenthippo.com are so much skilled, capable, talented, and experienced in their field and use our best and free Citation Generator and cite your writing assignments, so, for this, they can effectively write the best economics assignment help services.

Get Online Support for Capital Asset Pricing Model Answers Assessment Answer Assignment Help Online

Want to order fresh copy of the Sample Capital Asset Pricing Model Answers Assessment Answers? online or do you need the old solutions for Sample Capital Asset Pricing Model Answers Assessment Answer, contact our customer support or talk to us to get the answers of it.

Assignment Help Australia
Want latest solution of this assignment

Want to order fresh copy of the Capital Asset Pricing Model Answers Assessment Answers? online or do you need the old solutions for Sample Capital Asset Pricing Model Answers Assessment Answer, contact our customer support or talk to us to get the answers of it.


Submit Your Assignment Here

AssignmentHippo Features

On Time Delivery

Our motto is deliver assignment on Time. Our Expert writers deliver quality assignments to the students.

Plagiarism Free Work

Get reliable and unique assignments by using our 100% plagiarism-free.

24 X 7 Live Help

Get connected 24*7 with our Live Chat support executives to receive instant solutions for your assignment.

Services For All Subjects

Get Help with all the subjects like: Programming, Accounting, Finance, Engineering, Law and Marketing.

Best Price Guarantee

Get premium service at a pocket-friendly rate at AssignmentHippo

FREE RESOURCES

  • Assignment Writing Guide
  • Essay Writing Guide
  • Dissertation Writing Guide
  • Research Paper Writing Guide

FREE SAMPLE FILE

  • Accounts
  • Computer Science
  • Economics
  • Engineering

Client Review

I was struggling so hard to complete my marketing assignment on brand development when I decided to finally reach to the experts of this portal. They certainly deliver perfect consistency and the desired format. The content prepared by the experts of this platform was simply amazing. I definitely owe my grades to them.

Tap to Chat
Get instant assignment help