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Capital Asset

Capital Asset

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Published by anish143
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Published by: anish143 on Feb 02, 2010
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Capital Asset Pricing Model: The IndianContext
 R Vaidyanathan
T
he Capital Asset Pricing model is based on two parameter portfolio analysismodel developed by Markowitz (1952). This model was simultaneously andindependently developed by John Lintner (1965), Jan Mossin (1966) andWilliam Sharpe (1964). In equation form the model can be expressed asfollows:
E (R 
i
) = R 
+
β
i
[E(r
m
) – R 
] = R 
+
σ
im
/
σ
m
(E(R 
m
) – R 
/
σ
m
)
Where E(R 
i
) is expected return on asset i, R 
is the risk-free rate of return, E(R 
m
) isexpected return on market proxy and
β
i
; is a measure of risk specific to asset i. Thisrelationship between expected return on asset i and expected return on market portfolio isalso called the security market line. If CAPM is valid, all securities will lie in a straightline called the security market line in the E(R),
β
i
frontier. The security market lineimplies that return is a linearly increasing function of risk. Moreover, only the market risk affects the return and the investor receive no extra return for bearing diversifiable(residual) risk.The set of assumptions employed in the development of the CAPM can besummarized as follows [Sears and Trennepohl (1993)]:1. Investors are risk-averse and they have a preference for expected return and adislike for risk.2. Investors make investment decisions based on expected return and the variances of security returns, i.e. two-parameter utility function.3. Investors behave in a normative sense and desire to hold a portfolio that lies alongthe efficient frontier.These three assumptions were also made in the development of the Markowitz andSharpe single-index portfolio analysis models. In addition to these three, CAPM alsomakes the following assumptions.4. There exists a riskless asset and investors can lend or invest at the riskless rate andalso borrow at this rate in any moment.5. All investments are perfectly divisible. This means that every security and portfolio is equivalent to a mutual fund and that fractional shares for any investment can be purchased in any amount.6. All investors have homogenous expectations with regard to investment horizons or holding periods and to forecasted expected returns and risk levels on securities. Thismeans that investors form their investment portfolios and revise them at the sameinterval of time
 
 Research Papers in Applied Finance
(e.g., every six months). Furthermore, there is complete agreement among investors as tothe return distribution for each security or portfolio.7. There are no imperfections or frictions in the market to impede investor buyingand selling. Specifically, there are no taxes or commissions involved with securitytransactions. Thus there are no costs involved in diversification and there is nodifferential tax treatment of capital gains and ordinary income.8. There is no uncertainty about expected inflation; or, alternatively all security pricesfully reflect all changes in future inflation expectations.9. Capital markets are in equilibrium. That is, all investment decisions have beenmadeand there is no further trading without new information.Some of the above assumptions are clearly unrealistic. However, the assumptions arenot as restrictive as it appears initially and some of them can be relaxed without alteringthe basic nature of the model as we explain below. [Sears and Trennepohl (1993)]
Theoretical Implications of Relaxing the above-mentioned assumptions:
2. Inclusion of skewness (third moment) in the pricing model has led to the threemoment CAPM.4. a. Different borrowing and lending rates lead to different CAPM lines and nogeneral equilibrium pricing model. b. No riskless asset exists, leading to the zero beta CAPM, which provides for atheoretical explanation of the basic CAPM empirical results.c. There is riskless lending but no riskless borrowing, leading to the zero beta CAPM5. CAPM would be series of line segments, each representing portfolio positions withno fractional shares.6. Different expectations lead to different CAPM lines and no general equilibrium pricing model.7. a. Inclusion of transactions costs in the model would produce bands around therelationship, leading to fuzzy equilibrium.b. Consideration of taxes leads to an alternative CAPM model that incorporatesthe differential tax effects of dividends and capital gains.
Empirical Implications of Relaxing the above-mentionedAssumptions
2. The general conclusion of tests of this model indicate that skewness is important inthe pricing of securities. In particular, whenever the market portfolio is positively(negatively) skewed, investors are willing to accept (require) a lower (higher) averagereturn in exchange for positive skewness with the market portfolio.4. a. Assumption cannot be tested empirically, band c. some empirical studiessupport the zero beta CAPM, but others do not.5. Assumption has not been tested but is probably not a major empirical problem for CAPM.

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