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Capital Asset Pricing Model Financial concept named the Capital Asset Pricing Model (CAPM) is aimed to estimate the value of securities, stocks, assets and / or derivatives in the context of related risk and expected return. The main formula of the CAPM is the following: Expected Security Return = Risk-Free Return + Beta x (Expected Market Risk Premium), where Beta is overall risk at particular market, and Risk Premium is additional return, expected to be received by investors as a result of additional risk. Therefore, the model demonstrates the relationship between return and risks, and shows that the expected return from investments, which will be demanded by investors, must be equal to the rate of risk-free return plus extra return for additional risks at the market. The CAPM was introduced by William Sharpe and John Lintner in the mid 60 s as a concept of portfolio theory, presenting the ideas of systematic and additional risks, and it become the base for developing of asset pricing theory, for which William Shape won a Nobel Prize. The CAPM was an important issue to explore for many famous economic theorists, like J. Lintner or J.
Mission, who tried to study and analyze, to clarify and modify the empirical model. Specialists discovered that the main attractions of the CAPM are its simplicity and clear logic; it differentiates systematic and non-systematic risks and clearly shows variability of returns in context of one single factor of risk. It is quite easy to implement and to correct in case of markets high sensibility. The CAPM can be applied not only for valuing of expected returns from securities under specific risks; it can also be used as dividend valuating formula to estimate the expected value of shares. But, unfortunately, the CAPM becomes less and less effective tool for estimating of economical indexes in our developing economic theory. First of all, this model can be effective only at simplified absolute market conditions, like the absence of taxes and other charges of free trade, the absence of obstacle for entering the market, the absence of domination of any large particular investor, the availability for all the investments to be borrowed, the availability of risk-free securities and stocks, the homogeneousness in market perceptions and expectation from the side of all investors, etc.
Such market circumstances are possible only theoretically. There is number of other assumptions of the CAPM, which can be hardly applied for realistic conditions of market economy. The model presumes that all the investors have optimized portfolios and all of them (investors) are reluctant to risks, though it is not very correct. The CAPM assumes the divisibility of all the assets; that means it can not be applied for human capital (as it is not divisible). It does not consider other possible types of risks, like inflation risk or liquidity risk. Besides, in practice, it appears quite difficult to identify the structure and value of market portfolio and to estimate the risk free rate of return under different macroeconomic factors.
The CAPM is not flexible in time and it can be applicable as a model for the projects of less than one year. In addition, this model does not give information about the price of the stocks or securities, and it can not be correlated in the context of the particularity of the market on which the company is operating, so the company producing PC games can be as good as the one manufacturing missiles, in case if their Beta is the same. Therefore, some other alternative approaches and models (like the Arbitrage Pricing Model or the idea of Efficient Market Hypothesis) can be more effective for estimating of value of investments, applicability of which may vary depending on particular criteria of such estimation. But in anyway, the CAPM is still used by economists for evaluating of the performance of capitals and portfolios. This model remains the only one, which determines the risks and return, and it is among the central concepts, which is being given in investment courses and trainings of MBA level. Bibliography: Fama, E.
F. and French, K. R. , "The Capital Asset Pricing Model: Theory and Evidence" (August 2003). CRSP Working Paper No. 550; Tuck Business School Working Paper No. 03 - 26. Retrieved November 27, 2004 from the World Wide Web: < web > Javed, A. Y. , "Alternative Capital Asset Pricing Models: A Review of Theory and Evidence" (2000).
Pakistan Institute of Development Economics; Eldis, Gateway to Development, retrieved November 27, 2004 from the World Wide Web: < web >
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Research essay sample on Capital Asset Pricing Model
