2. overview
ο About CAPM
ο Assumptions of CAPM
ο Market Efficiency
ο Advantages of CAPM
ο Disadvantages of CAPM
ο Conclusion
3. ABOUT CAPM
οIt represents the linear relationship between the return
required on an investment and its systematic risk
οIt is represented by the formula:
Ke = Rf +Ξ² (Rm β Rf)
οKe = Risk free rate + Risk premium
4. BETA (SYSTEMATIC RISK)
Ξ² = cov. (K e , R m )
Ξ΄M
2
Value of Ξ² Characteristics of security
Ξ² < 1 Less sensitive to market
Ξ² = 1 Equally sensitive to market
Ξ² > 1 More sensitive to market
7. ASSUMPTIONS OF CAPM
οInvestors hold diversified portfolios
οSingle-period transaction horizon
οInvestors can borrow and lend at the risk-free rate of
return
οPerfect capital market
12. ADVANTAGES OF CAPM
ο It considers only systematic risk, reflecting a reality in
which most investors have diversified portfolios from
which unsystematic risk has been essentially eliminated
ο It generates a theoretically-derived relationship between
required return and systematic risk which has been
subject to frequent empirical research and testing
ο It is generally seen as a much better method of
calculating the cost of equity than the dividend growth
model (DGM) in that it explicitly takes into account a
companyβs level of systematic risk relative to the stock
market as a whole
13. Disadvantages
ο The model assumes that asset returns are (jointly)
normally distributed random variables
ο The model assumes that the variance of returns is an
adequate measurement of risk
ο The model does not appear to adequately explain the
variation in stock returns
ο The model assumes that given a certain expected
return investors will prefer lower risk (lower variance)
to higher risk and conversely given a certain level of
risk will prefer higher returns to lower ones
14. Contdβ¦β¦
ο The model assumes that all investors have access to
the same information and agree about the risk and
expected return of all assets
ο The market portfolio should in theory include all
types of assets that are held by anyone as an
investment (including works of art, real estate, human
capital...)
15. conclusion
Research has shown the CAPM to stand up well to
criticism, although attacks against it have been
increasing in recent years. Many other models have
been developed which are used extensively these days
like Fench and Fama Model. However, the CAPM
remains a very useful item in the financial
management toolkit.