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CAPM (Capital Asset Pricing Model) is a technique to measure the rate of return of an asset which is requires to be added to an existing

diversified portfolio provided that asset is not prone to a non-diversifiable risk. The model considers the sensitivity of an asset to a non-diversifiable risk often called market risk or symmetric risk that is symbolized by ? (beta) and expected market return. CAPM is pretty good for pricing a portfolio or individual industry. To price the individual securities, security market line that helps calculating reward-to-risk ratio for securities. The factors can be mathematically related as:

The reward-to-risk ratio can also be termed as market risk premium. The above equation can also be arranged as:

Where E(Ri) is Expected return on capital asset Rf is risk free interest rate is sensitivity of expected excessive asset return to expected excess market return and can be expressed as E(Rm) is expected return of market often called the risk premium or the market premium We can restate the equation as: Security market line The graph plotted for the values obtained from the CAPM formula is called the Security Market Line or simply SML Relation for SML is thus:

Asset pricing

We can take decision on an investment opportunity after evaluating the E(Ri) from CAPM as the comparison of required rate of return to the expected rate of return of asset will reveal the situation of the asset. An asset is said to priced correctly when its estimated price correlates present value of assets future cash flows with CAPMs suggested discount rate. The asset is said to be overvalued if CAPMs valuation goes higher than the observed price and undervalued in the converse state. Asset-specific required return The CAPM Model brings the appropriate discount rate or the required rate of return for the asset. If beta exceeds one, the asset is risk more than average and in the beta lies below one, the asset is risky less than average. High beta values will always be associated to highly risky stocks that will always have high discounts and vice versa. Assumptions of CAPM All Investors:

Aspire to maximizing the economic utilities Look for risk-avers and rational conditions Are the price takers i.e they never influence prices Borrow and lend unlimited amounts under risk free interest rate Trade without taxation or transaction costs Deal with securities which can easily be divided into small parcels Assume that they have access to all information as and when they require it

Pitfalls of CAPM

The model relies on the assumption that either the investors employ some sort of quadratic form of efficacy or the asset returns are normally distributed random variables. Is has been observed more than often that return on equity and other market is not distributed normally. This is why the market faces a 3-6 standard deviation swing from the mean. The model suggests that variance of returns can help measuring the risk adequately. In financial investments, risk is not it self a variance but more accurately it can be called as the probability to lose; it has an absolutely asymmetric nature. Another assumption of the model says that information is accessible to all investors equally and with same degree of consistency. The model seems to fail in explaining the variation in the stock return. Empirical studies reflect that low beta stocks have also good chances to pay higher. Another assumption of the model suggests an absence of the transaction and tax costs although there are complicate versions of CAPM that ignore this assumption.