Capital Asset Pricing Model (CAPM)
Capital asset pricing model (CAPM) refers to a model that is used in finance in determining the theoretically appropriate rate of return of a given asset that is required by an asset so that it can be added to a well-diversified portfolio that already exists considering the non-diversified risk of the asset. This model describes how expected returns and risk relates and it is commonly used in pricing risky securities.
The model takes sensitivity of the asset to non-diversifiable risk into account. Non-diversifiable risk is also called the market risk or systematic risk and in financial industry it is usually represented by a quantity beta (β). The model also considers the expected returns for the market as well as the expected returns for a theoretical asset that is free of risk.
According to capital asset pricing model, beta determines the cost of equity of an investor. Jack Treynor introduced the capital asset pricing model between 1961 and 1962. William Sharpe, John Lintner and Jan Mossin contributed on the model independently in the later years. All these scholars were building their concepts on the earlier work by Harry Markowitz on modern portfolio and diversification theory. Merton Miller, Markowitz and Sharpe were jointly given the Nobel Memorial Prize in Economics in 1990 for their contribution in the financial economics field.
Another version of capital asset pricing model was developed by Fischer Black in 1972 known as the Black CAPM or the Zero-beta CAPM. This model does not assume that riskless asset exists. The model was robust against the empirical testing. It was highly influential in the overall adoption of CAPM. Despite having empirical flaws and more contemporary approaches, capital asset pricing model is still popular because it is simple and it can be used in different situations.
Going by the capital asset pricing model, an investor deserves compensation in two different ways. These are time value of their money and risk.
Time value of the money that an investor spends on a project is represented by a risk-free (rf) rate. It offers compensation to an investor for having put their money in an investment project for specified duration. The risk compensation caters for additional risk that an investor takes by investing money in a project. It is calculated using risk measure or beta that provides a comparison for the asset’s returns against the market over duration that the investor invests and market premium. The capital asset pricing model states that, expected returns of a portfolio or security equals rate on risk-free security and risk premium.
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