Capital Inset Pricing Model: The Capital Asset Pricing Model

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The capital asset pricing model (CAPM) serves as a model for the pricing of risky securities. CAPM believes that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, the investment should not be taken. The CAPM helps us to calculate investment risk and what return on investment we should expect. Systematic Risk is market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks. While unsystematic risk is known as "specific risk," this risk is specific to individual stocks and can be diversified away as the investor increases the number of stocks in his or her portfolio.…show more content…
It seems to consider only systematic risk which reflects a true life scenario in which many future investors would have diversified portfolios from which unnecessary risk would have been essentially eliminated. It also generates a theory given relationship between the required return and systematic risk which has been known to frequent empirical research and testing. Thus, this is known to be a better method of calculating the cost of equity than the dividend growth model (DGM) in that it specially takes into consideration of a company’s level of systematic risk relative to the stock market as a whole. Overall, CAPM is a simplistic calculation that can be easily tested to derive a range of possible outcomes to provide confidence around the required rates of return. Even with the diversified portfolio, the assumption that investors hold a diversified portfolio, similar to the market portfolio, eliminates unsystematic (specific) risk. Systematic Risk (beta): CAPM takes into consideration account systematic risk, which is left out of other return models, such as the dividend discount model (DDM). When businesses investigate opportunities, if the business mix and financing differ from the current business, then other required return calculations, like weighted average cost of capital cannot be used. However, CAPM…show more content…
A return over six months, for example, cannot be compared to a return over 12 months. A holding period of one year is usually used. Investors can borrow and lend at the risk-free rate of return thus this is an assumption made by portfolio theory, from which the CAPM was developed, and provides a minimum level of return required by investors. Since the real-world capital markets are clearly not perfect, it can be argued that well-developed stock markets do, in practice, exhibit a high degree of efficiency, there is scope for stock securities to be priced incorrectly. A more serious problem is that, in reality, it is not possible for investors to borrow at the risk-free rate. The reason for this is that the risk associated with individual investors is much higher than that associated with the Government. This inability to borrow at the risk-free rate means that the slope of the SML is shallower in practice than in
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