![]() Some of the challenges in using the Capital Asset Pricing Model analysisĭespite having the simple procedure of computation and providing the specification on the past performance of the stocks, CAPM analysis still faces some problems in its implementation (Rai, 2011) i.e. A company having a higher beta value tends to have more risk but also earn more return (Kenton & Westfall, 2020). Examining the fluctuations in the prices of the stocks, Beta measures the sensitivity of the stocks to systematic market risk. Betaīeta in the Capital Asset Pricing Model specifies the market volatility. Treasury bills are mainly considered risk-free assets wherein the rate of return is adjusted to the inflation rate (Chen & Scott, 2020). It is the return that the investor would get over a specific time period. It represents the return earned from the asset having zero risk associated. the assumption about the expected long-term return from investing in a particular asset (CFI, 2020). It represents the behaviour of the investment i.e. Some of the firm-specific factors which lead to the occurrence of such risks are management changes, strikes, or any specific export order.įurther, some of the terms used while implementing the Capital Asset Pricing Model are The expected return on investment Thus, unsystematic risks could be diversified by the investor. This form of risk arises from firm-specific factors and is not due to movements in the market factors. Some of the factors which lead to systematic risk are recession, interest rate, boom conditions, or war. As these risks are non-diversifiable thus investor has to bear them. Systematic risk represents the variability in the return that the investor has to bear due to market factors. William Sharpe, the financial economist, while explaining the concept of CAPM has explained in his book Portfolio Theory and Capital Markets (1970) that investors have to face two types of risk (Chan, 2010 Mcclure, 2019) i.e.įigure 2: Types of investment risks Systematic risk Terminologies related to Capital Asset Pricing Model Thus, no new issues will be undertaken in the market and not much focus is on the investor’s requirement of liquidity. All the assets are divisible and even marketable. There is an identical time horizon for all investors thus depicting that time has no relevance in influencing the rate of expected return.This would lead to depicting a single efficient frontier or having homogeneity in the conception. The investor has similar expectations for return as well as risk.Thus, in order to reduce risk, an investor could either borrow at a risk-free rate or add risk-free assets to the portfolio. There is no limit on the borrowing or lending of assets by an investor.Thus, the price of the stock is not influenced by any single investor’s decision. free access to all information is available to all the investors wherein no extra cost or time is involved. There is the existence of perfect competition in the market i.e.By diversifying the risk, investors under the CAPM consider the expected returns and variance (systematic risk measured by beta) before making any decision about an efficient portfolio. ![]() Investors make their investment decisions based on the complete assessment of risk and return.Thus, an investor aims at maximizing benefits, considering his preference for risk and return. some prefer more risk while others value less risk. This is because each investor has different preferences i.e. An investor does not aim at maximizing return or wealth but instead focuses on maximizing the utility derived from the wealth.The usage of the CAPM is based on the existence of certain assumptions (Diksha, 2020 Rai, 2011). Β: Beta of the investment Pre-conditions or assumptions for the applicability of the Capital Asset Pricing Model R m: Expected Market return on the security This model determines the expected return on investment by considering the risk attached to those assets and the cost of capital (CFI, 2020). The capital Asset Pricing Model studies the relationship between the systematic risk of investing and the expected return. Understanding the concept of the Capital Asset Pricing Model The Capital Asset Pricing Model (CAPM) has emerged as a practical approach to calculating stock value (Fama & French, 2003). Stock prices are important while calculating risk in stock and optimizing the portfolio value of an investor. However, over the years the theory has received criticism as it fails to take into consideration the asset or stock prices (Liu, 2017), instead only accounting for risk and return. The theory received widespread acclaim and the Nobel Prize. Harry Markowitz’s Modern Portfolio Theory (MPT) is one of the most renowned theories on how risk-averse investors can construct an optimal portfolio for maximizing the financial returns on their investments with minimal risk.
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