Capital Asset Pricing Model (CAPM)
Introduction
} The capital asset pricing model was developed by the financial economist (and later, Nobel laureate in economics) William Sharpe, set out in his 1970 book Portfolio Theory and Capital Markets. His model starts with the idea that individual investment contains two types of risk:
} Systematic Risk – These are market risks—that is, general perils of investing—that cannot be diversified away. Interest rates, recessions, and wars are examples of systematic risks.
} Unsystematic Risk – Also known as "specific risk," this risk relates to individual stocks. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves
} No matter how much you diversify your investments, some level of risk will always exist. So investors naturally seek a rate of return that compensates for that risk. The capital asset pricing model (CAPM) helps to calculate investment risk and what return on investment an investor should expect.
The CAPM can
be calculated with the CAPM formula as follows:
ERi = Rf + βi(ERm-Rf)
} ERi = Expected return of investment
} Rf = Risk-free rate
} βi = Beta of the investment
} ERm = Expected return of the market
} (ERm – Rf) = The market risk premium, which is calculated by subtracting the risk-free rate from the expected return of the investment account.
The benefits of CAPM
include the following:
} Ease of use and understanding
} Accounts for systematic risk
The limitations of
CAPM include the following:
} Experts believe it is too simplistic because it does not cover all of the risks that are involved with investing
} It does not correctly evaluate reasonable returns
} Assumes that you can lend and borrow at a risk-free rate
} Returns that are calculated evaluate past returns and might not accurately reflect future returns
No comments:
Post a Comment