Explain the proposition of capital asset pricing model 1 and 2
Answers
The proposition of capital asset pricing model 1 and 2...!!
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.
Modern portfolio theory shows that specific risk can be removed or at least mitigated through diversification of a portfolio. The trouble is that diversification still does not solve the problem of systematic risk; even a portfolio holding all the shares in the stock market can't eliminate that risk. Therefore, when calculating a deserved return, systematic risk is what most plagues investors.
The CAPM Formula
CAPM evolved as a way to measure this systematic risk. Sharpe found that the return on an individual stock, or a portfolio of stocks, should equal its cost of capital. The standard formula remains the CAPM, which describes the relationship between risk and expected return.
Here is the formula:
Ra =Rrf +βa∗(Rm−Rrf)
where:
R a =Expected return on a security
R rf =Risk-free rate
R m =Expected return of the market
β a =The beta of the security
(Rm−R rf)=Equity market premium
CAPM's starting point is the risk-free:
rate–typically a 10-year government bond yield. A premium is added, one that equity investors demand as compensation for the extra risk they accrue. This equity market premium consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta."
Beta's Role in CAPM
According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's relative volatility–that is, it shows how much the price of a particular stock jumps up and down compared with how much the entire stock market jumps up and down. If a share price moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10% and fall by 15% if the market fell by 10%.
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Answer:
:The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. CAPM assumes a particular form of utility functions (in which only first and second moments matter, that is risk is measured by variance, for example a quadratic utility) or alternatively asset returns whose probability distributions are completely described by the first two moments (for example, the normal distribution) and zero transaction costs (necessary for diversification to get rid of all idiosyncratic risk). Under these conditions, CAPM shows that the cost of equity capital is determined only by beta. Despite it failing numerous empirical tests, and the existence of more modern approaches to asset pricing and portfolio selection (such as arbitrage pricing theory and Merton's portfolio problem), the CAPM still remains popular due to its simplicity and utility in a variety of situations.The CAPM is a model for pricing an individual security or portfolio. For individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class. The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:
{\displaystyle {\frac {E(R_{i})-R_{f}}{\beta _{i}}}=E(R_{m})-R_{f}}
The CAPM was introduced by Jack Treynor (1961, 1962), William F. Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly received the 1990 Nobel Memorial Prize in Economics for this contribution to the field of financial economics. Fischer Black (1972) developed another version of CAPM, called Black CAPM or zero-beta CAPM, that does not assume the existence of a riskless asset. This version was more robust against empirical testing and was influential in the widespread adoption of the CAPM.