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Investment Opportunity Run Your Own Energy Saving Business PLC Seeks International Partners The capital asset pricing model (CAPM) is a mathematical model that seeks to explain the relationship between risk and return in a rational equilibrium market. Developed by academia, the CAPM has been employed in applications ranging from corporate capital budgeting to setting public utility rates. The CAPM provides much of the justification for the trend toward passive investing in large index mutual funds.

its lost customers will go to a different fast food establishment. Regardless of product quality or executive ability. called systematic risk. and Jan Mossin simultaneously and independently developed the CAPM. Systematic risk is risk that cannot be removed by diversification. a firm's profitability will be influenced by economic trends. by holding many different assets. is due to general economic uncertainty. highly respected journals during the period of 1964-66. RISK AND THE CAPM The treatment of risk in the CAPM refines the notions of systematic and unsystematic risk developed by Harry M. on average. since it seemed to indicate that professional investment management was largely a waste of time. For example. Their research appeared in three different. When the CAPM was first introduced. John Lintner. or company-specific. The key element of the model is that it separates the risk affecting an asset's return into two categories.. ideas. In general. specific senior employees may make good or bad decisions or the same type of manufacturing equipment utilized may have different reliabilities at two different sites.William Sharpe. if one fast food company makes a bad policy decision. This type of risk represents the necessary risk that owners of a firm must accept when launching an enterprise. etc. The first type is called unsystematic. the investment community viewed the new model with suspicion. such as changes in senior management or product lines. Markowitz in the 1950s. The investor in both companies will find that the losses in the former investment are balanced by gains in the latter. . equal the yield on a risk-free bond held over that time plus a premium proportional to the amount of systematic risk the stock possesses. random fluctuations in the value of one will be offset by opposite fluctuations in another. unsystematic risk is present due to the fact that every company is endowed with a unique collection of assets. That is. risk. It was nearly a decade before investment professionals began to view the CAPM as an important tool in helping investors understand risk. This risk represents the variation in an asset's value caused by unpredictable economic movements. The CAPM states that the return on assets should. The long-term average returns for this kind of risk should be zero. whose aggregate productivity may vary. personnel. For example. Unsystematic risk is the risk to an asset's value caused by factors that are specific to an organization. A fundamental principle of modern portfolio theory is that unsystematic risk can be mitigated through diversification. The second kind of risk.

Diversification is simple. Therefore.In the capital asset pricing model. Mathematically. The returns of an asset where 13 = I will. move equally with the returns of the overall market. Treasury bill β i = beta coefficient or index of non-diversifiable risk for asset i k m = the return on the market portfolio of assets ASSET RETURNS IN THE CAPM The CAPM models return to an asset by the following three guidelines. all assets must have an expected return of at least the return to a risk-free bond (except for rare assets with (3 < 0. such as Standard and Poor's 500 or the Wiltshire 5000. while those with a > I will show return fluctuations greater than the overall market. These large equity indexes are commonly viewed as bench-marks against which a securities performance is judged. does not affect the economics of the assets being held.S. Second. First. or correlation to the market average. The market's return is most often represented by an equity index. The rationale is that any risky asset must be expected to return at least as much as one without risk or there would be no incentive for anyone to hold the risky asset. The preceding paragraphs are summarized in the following equation: Where: K i = the required return on asset i R f = risk-free rate of return on a U. and only helps the investors holding the assets. . Assets with β < I will display average movements in return less extreme than the overall market. on average. the risk associated with an asset is measured in relationship to the risk of the market as a whole. there is no compensation inherent in the model for accepting this needless risk by choosing to hold an asset in isolation. which will be discussed below). there is no expected return to taking unsystematic risk since it may easily be avoided. (is defined as the covariance of an asset's returns divided by the variance of the market's return. This is expressed as the stock's a (beta).

may summarize the preceding discussion: Where: E[R i ] is the expected return to asset i R f is the risk free rate of return β im is asset i 's market Beta E [ R m — R f ] is the expected market risk premium Graphically. The assumptions that form the basis for the CAPM are: . Some are vital to its premise. meaning the asset's expected return is less than the risk-free rate. which has the following equation. This amount is modified by the (3 which scales it up or down depending on the asset's sensitivity to market movements. assets that are subject to systematic risk are expected to earn a return higher than the risk-free rate. others cause only minor changes if they are untrue. Examples of this type of asset are precious metals. The Security Market Line (SML). the higher the average long-term return must be for the holder to be willing to accept the risk. Since the early 1970s much research into the plausibility and effects of weakness in these assumptions has been conducted by academia. This risk cannot be diversified away and must be borne by the investor if the assets are to be financed and employed productively. Ibbotsen and R. The higher the systematic risk. Assets with negative returns are those that actually hedge against general economic risk. Sinquefield to average about 6. some assets have a negative premium. doing well when the economy performs poorly.Finally. This premium should be incremental to the risk free rate by an amount proportional to the amount of this risk present in the asset. This is because their (3 is less than zero. The market risk premium was reported by R. ASSUMPTIONS OF THE CAPM The CAPM draws conclusions from a variety of assumptions.1 percent. the SML may be represented by the graph in Figure 1. Interestingly.

This is especially true if the assumptions regarding short sales and risk free borrowing are violated. EMPIRICAL TESTS OF THE CAPM Two early tests of the CAPM revealed that the model was conceptually sound except that the Security Market Line intercept was estimated to be approximately 3 to 4 percent higher than the risk-free rate. Since no one can observe the true market portfolio. •All possible investments are traded in the market and are available to everyone. •Investors always desire more return to less. R.•Investors measure asset risk by the variance of its return over future periods. rather than a beta calculated using a market index. EXTENSIONS OF THE CAPM . In addition. Roll wrote a famous article in which he argued that tests of the CAPM are inherently impossible. every investor receives and understands the same information. the assets are infinitely devisable. only average realized ones. processes it accurately. All other measures of risk are unimportant. and different average returns on Friday and Monday from that of other days of the week. but its basic point is the following. that is. it is impossible to know whether the correct relationship is actually being tested. and trades without cost. There is no consideration of the effects of taxation. •The market is perfectly efficient. and they are risk averse. Examples include seasonal fluctuations (such as unusually high returns for some companies in January). only a proxy index. and since no one can actually observe expected returns. and there are no restrictions on short selling. More recent tests of the CAPM show that there are many apparent shortcomings of the strict interpretation of the model. That is. •There are no restrictions on the borrowing and lending of money at the risk-free rate of interest. they will avoid risk if all else is equal. some analysts have argued that stock returns are more closely related to the book value and total variability of the stock. This is consistent with a CAPM model where money cannot actually be borrowed at the risk-free rate. The article is quite technical. Others argue that many apparent inconsistencies can arise in the CAPM because a capital weighted index (such as the S&P 500) may not be an appropriate proxy for the market portfolio.

In the APT.In 1976. or more sophisticated investing. 2. transformed. most notably for forward exchange rates and for futures markets. S. APPLYING THE CAPM Despite limitations.To earn a higher return. its principles are very valuable. The resulting Consumption Capital Asset Pricing Model (CCAPM) is much more complex than its non-temporal counterpart. unless the model is based on market inefficiencies. it is less intuitive and more difficult to implement. and may function as a sufficient guide for the average long-term investor. it will still have the CAPM basic tenets at its center. The more stocks one holds that are sensitive to the business cycle the more average return the portfolio will receive. investors consider the consequences of decisions over multiple periods. or obtaining superior information. which avoids the need for specifying a market portfolio.Hold long term—do not worry about timing when to get in or out of the market. However. Many other adaptations of the CAPM are in use.Diversify—there is no compensation for unsystematic risk. It is a validation of the widespread applicability of the CAPM that so many individuals have improved. the Capital Asset Pricing Model remains the best illustration of long-term tradeoffs between risk and return in the financial markets. These principles may be stated as: 1. Although very few investors actually use the CAPM without modification. Cousins ] . Another attempt to modify the CAPM involves adjusting it for temporality. It has been shown to work successfully in situations where the normal CAPM has failed. instead of over the next period only. as the CAPM assumes. [ Rick A Cooper updated by Joan K. other models have been developed. take on more systematic risk. Although this model is generally believed to be more powerful than the CAPM. an asset's return is related to multiple economic factors instead of the market portfolio. or modified it to fit specific situations. For shorter term. 3. the Arbitrage Pricing Theory (APT). With temporal modeling. Ross published a different model.

the CAPM inherits all the shortcomings of the latter in addition to its own assumptions such as: more: Capital Asset Pricing Model (CAPM) http://www.referenceforbusiness.html#ixzz1tdwl5uhY CAPM assumptions Currently 5/5 Stars. 2009 February 13. 2009 Public 15520 Would you like to. 12345 Article Details February 13.. Print this page Email this page Leave a comment Add to favorites Export to pdf View favouritesThe assumptions of the Capital Asset Pricing Model explaining its limitations when using for a hedge fund assessment Based on the Markowitz’s mean-variance model.

Investors are rational and risk averse. The total number of assets on the market and their quantities are fixed within the defined time frame. inflation. The information is costless. and all investors receive the same information simultaneously. 3. all investors agree about mean and variance as the only system of market assessment. Asset returns conform to the normal distribution. 2. 5. 7. Implication: The model includes the single time horizon for all investors. transaction costs. and no individual can affect the price of a security. All assets are infinitely divisible and perfectly liquid. thus everyone perceives identical opportunity. somebody has to prove that this simple model really holds true in the market. 8. In other words. They pursue the only interest of maximizing the expected utility of their end of period wealth. Investors have homogenous expectations about asset returns. The markets are perfect. While the CAPM emerges as the most commonly used approach for both institutional and private investors. . Investors can borrow and lend unlimited amounts at the risk-free rate (erf ). and short selling restrictions are not taken into account. thus taxes. The markets are in equilibrium.1. 4. 6.