Capital Asset Pricing Model
The Single Index Model (SIM) and the Capital Asset Pricing Model (CAPM) are models that are used to pronounce the association between the risk and the expected return, in addition to pricing or valuation of risky investment assets.
The Capital Asset Pricing Model (CAPM)
According to Bodie (2003) the capital asset pricing model, also referred to as the CAPM, originated from the work of Harry Markowitz in 1952. The CAPM provides an accurate extrapolation of the association that should be observed between expected return and the risk of a stock. This relationship provides two important functions. That is, it gives a yardstick rate of return for assessing potential investments. For example, an analyst may want to deduce if the expected return
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That is unsystematic risk or company specific risk whereby the long term average returns should be zero. Secondly there is systematic risk, which is due to the general economic uncertainty. The capital asset pricing model states that the return on assets should, on average equal the yield on a risk free bond held over that time plus premium proportional to the amount of systematic risk the stock possesses.
The assumptions for the CAPM are; Every investor has equal access to all securities, All individual investors are price takers, There are no taxes, All Investors plan over the same financial period, Lending or borrowing by investors is at a uniform risk free rate, All investors have homogenous investments opportunities perceptions, There no commissions or taxes, Investors have equal access to investments assets and Investors only care about expected risk and
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The CAPM is widely criticised for being too unrealistic based on its many assumptions compared to the SIM in many scenarios. The CAPM model does not compensate for firm specific risk since not all investors can diversify their portfolio cheaply due to excessive transaction costs. In real life, investors always face pronounced unsystematic risk as proffered by the SIM. If an asset faces a high unsystematic risk, CAPM will not capture it. The model also has an unrealistic assumption that firms can borrow and lend at risk free
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