CAPM (Capital Asset Pricing Model) Essay Example | Topics and Well Written Essays - 1750 words

CAPM (Capital Asset Pricing Model) - Essay Example and expected returns which is denoted as r. The ? is used as a measure of non diversified risk and implies that the expected return is the return on a risk free asset in addition to a risk premium (Laubscher, 2002). The risk premium will be equivalent to the market return in surplus of the risk free rate which is multiplied by the share portfolio. This is the reason that ? is regarded as the difference between the returns on various share portfolio. The formula for CAPM model is denoted below: R = Rf + ?(Rm - Rf) R = Expected return on the share/portfolio. Rf = Risk-free rate of return. ? = Beta (volatility of the share/portfolio relative to the market portfolio). Rm = Expected return on the market portfolio. Rm - Rf = Market risk premium (Laubscher, 2002). In the CAPM model risk is defined as the extent to which returns on share portfolio have covariance and variance with the market returns. ? is used for measuring risk and the basis for expected market returns. It is used as a meas ure for non diversified risk and is a relative measure of risk relative to the market portfolio. ... Government bonds and Treasury bills are used instead of this instrument (Laubscher, 2002). 2. Return in the market: The market portfolio constitutes of all kinds of risky assets and is one of the most available diversified portfolios. After the valuation of portfolio is done then it will be difficult to diversify the risk. The market return is the return on the market portfolio which constitutes of all risky assets. The rate of return is actually measured by the approximation of the stock indices which is used a proxy to the market. However, the problem arises regarding the choice of the index to be used as a proxy (Laubscher, 2002).The expected rate of return depends upon the market risk but it also depends upon the nature of the benchmark of the portfolios. However, investors are satisfied in investing in a limited number of benchmark portfolios. 3. Beta (?): This is one of the most crucial aspects of the CAPM model; as it helps in determining the difference between the expected ma rket return and the actual market rate of return. Portfolio betas are usually derived from the historical data and are useful in the measurement of the betas of the future (Rai University, n.d.). According to economic analysts the high beta shares tend to have a higher returns and lower betas shares tend to have low returns. The relationship between the average returns and beta is linear but the slope of risk and return relationship is not as steep as estimated by the CAPM model. Beta measures the relationship based on past returns and the derived results are more accurate than the standard deviation used to measure the relationship between risk and returns (Laubscher, 2002). Figure 1: Relationship of risk & return as per CAPM Model (Source: Myers, 2003) From the