Outline and discuss the Capital Asset Pricing Model (CAPM) as means of Essay - 2

Outline and discuss the Capital Asset Pricing Model (CAPM) as means of valuing securities and their risk. What are the drawbacks - Essay Example The CAPM focuses on a single holding period and assumes the investors can borrow or lend at the risk free rate. There are no limits on short sales and all investors have homogenous estimates of return, risk, and variances. There are no taxes and transaction costs and all assets are highly liquid and marketable. The quantities of the assets are fixed and there is perfect market meaning investors cannot influence price and are price takers. The CAPM is based on the Capital Market line and the Security Market Line. The CML implies that all investors under the CAPM assumption must hold a combination of risk free securities and a market portfolio. If the market is in equilibrium the market portfolio will consist of every security in the same proportion as it is in the market. The CML specifies the relationship between an efficient market portfolio’s risk and return. CAPM focuses on individual securities as well and the SML defines the relationship between the risk and return of ind ividual securities which can be figured out by using the risk premium formula RPm = (km –krf) bm The required return on a specific stock according to CAPM would be the sum of the risk free rate and the product of the risk premium into beta. ... Beta is the relevant risk of an asset and is calculated as the gradient of the characteristic line which is the plotting of historical returns of an individual stock. Beta measures the volatility of returns compared to the volatility in the market. It is the measure of risk used in the SML whereas standard deviation is used as the market risk measure in CML. Although, CAPM has been used in security valuations its assumptions do not reflect a real market setting. As most investors in the real world do not hold fully diversified efficient portfolios, the beta would not be a sufficient measure of risk and SML would not be applicable for the required rates of return. As there are taxes and transaction costs in reality and assets have different degrees of liquidity this assumption does not hold true either. All investors do not have same forecasts of expected risk and return and they usually borrow according to their credit standing which is higher than the risk free rate. There is a disp arity in borrowing and lending rates which will distort the CML and thus the SML line. In many markets, large investors can influence price through buying and selling securities. Examples: Example 1: Krf= 6% Km=5% Beta for Kellogs foods is 1.2 Then the cost of equity would be = 6 + ( 6-5 ) 1.2 = 7.2 Example 2: The CAPM can be used to calculate the cost of common stock through the insertion of the risk free rate, expected market risk premium and the beta coefficient into the SML equation. For example: Krf= 8% Km=12% Beta for Kellogs foods is 1.2 Then the cost of equity would be = 8 + ( 12-8 ) 1.2 = 8 + 4.8 = 12.8 % The required return on Kellog’s stock would be 12.8%, 0.8% greater than the market return as its beta is greater than 1. However, due to