Explain cost asset pricing model and its assumptions
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Definition
The capital asset pricing model (CAPM) is the equation that describes the relationship between the expected return of a given security and systematic risk as measured by its beta coefficient. Besides risk the model considers the effect of risk-free interest rates and expected market return.
Assumptions
Basic assumptions of the CAPM model are as follows.
Markets are ideal—no transaction fees, taxes, inflation, or short selling restrictions.
All investors are averse to risk.
Markets are highly efficient. All investors have equal access to all available information.
All investors can borrow and lend unlimited amounts under a risk-free rate.
Beta coefficient is the only measure of risk.
All assets are absolutely liquid and infinitely divided.
The amount of available assets is fixed during a given period of time.
Markets are in equilibrium. All investors are price takers, not price makers.
Return of all available assets is subject to normal distribution function.
Formula
The CAPM model allows you to assess the expected return of a given security using the following formula:
E(Ri) = RF + βi × (E(RM) - RF)
where E(Ri) is an expected return of a security, RF is a risk-free rate, βi is the beta coefficient of a security, and E(RM) is an expected market return.
Market risk premium (RPM) can be calculated as follows.
RPM) = E(RM) - RF
The risk premium of a given security (RPi) can be assessed as follows:
RPi) = βi × (E(RM) - RF)
Example
Let’s assume an investor is thinking of buying one of three stocks: Stock A with a beta of 0.85, Stock B with a beta of 1.25, and Stock C with a beta of 1.65. If the risk-free rate is 4.50% and the expected market return is 12.35%, the expected return of each security can be assessed under CAPM.
E(RA) = 4.50 + 0.85 × (12.35 - 4.50) = 11.17%
E(RB) = 4.50 + 0.85 × (12.35 - 4.50) = 14.31%
E(RC) = 4.50 + 0.85 × (12.35 - 4.50) = 17.45%
Thus, a relationship exists between risk and the expected return of a security. So, the higher the beta, the higher the expected return and vice versa.
HOPE IT HELPS PLZ MRK AS BRAINLIST
Definition
The capital asset pricing model (CAPM) is the equation that describes the relationship between the expected return of a given security and systematic risk as measured by its beta coefficient. Besides risk the model considers the effect of risk-free interest rates and expected market return.
Assumptions
Basic assumptions of the CAPM model are as follows.
Markets are ideal—no transaction fees, taxes, inflation, or short selling restrictions.
All investors are averse to risk.
Markets are highly efficient. All investors have equal access to all available information.
All investors can borrow and lend unlimited amounts under a risk-free rate.
Beta coefficient is the only measure of risk.
All assets are absolutely liquid and infinitely divided.
The amount of available assets is fixed during a given period of time.
Markets are in equilibrium. All investors are price takers, not price makers.
Return of all available assets is subject to normal distribution function.
Formula
The CAPM model allows you to assess the expected return of a given security using the following formula:
E(Ri) = RF + βi × (E(RM) - RF)
where E(Ri) is an expected return of a security, RF is a risk-free rate, βi is the beta coefficient of a security, and E(RM) is an expected market return.
Market risk premium (RPM) can be calculated as follows.
RPM) = E(RM) - RF
The risk premium of a given security (RPi) can be assessed as follows:
RPi) = βi × (E(RM) - RF)
Example
Let’s assume an investor is thinking of buying one of three stocks: Stock A with a beta of 0.85, Stock B with a beta of 1.25, and Stock C with a beta of 1.65. If the risk-free rate is 4.50% and the expected market return is 12.35%, the expected return of each security can be assessed under CAPM.
E(RA) = 4.50 + 0.85 × (12.35 - 4.50) = 11.17%
E(RB) = 4.50 + 0.85 × (12.35 - 4.50) = 14.31%
E(RC) = 4.50 + 0.85 × (12.35 - 4.50) = 17.45%
Thus, a relationship exists between risk and the expected return of a security. So, the higher the beta, the higher the expected return and vice versa.
HOPE IT HELPS PLZ MRK AS BRAINLIST
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