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How satisfactory is capital asset pricing model as an asset pricing theory?
In finance the capital asset pricing model (CAPM) is used to determine a theoretically appropriate required rate of return of an asset if that asset is to be added to an already well-diversified portfolio, given that asset’s non-diversifiable risk. (Wikipedia)
Only a person who understands what Capital Asset Pricing Model is can answer this question. So we need to understand what CAPM is. Let me give you an example so that we can easily understand what is it all about? Capital Asset Pricing Model has and why is it so popular theory that is being used all over the world in the arena of stock market? We are not going into the technical difficulty of its depth but we are going to discuss its theory and system in laymen’s term so it can be easily understood.
Let us say that you have a 00 U.S. Dollars at hand and you would like to invest it in something worthwhile, you may then go out to plan and look for ways how you can place you money for the purpose of investment. At first you have found a bank that offers you 4% risk free interest, it is risk free since the government will provide a guarantee for your money whatever happen to the bank if ever there has been a bankruptcy they will still pay for your money. Will you invest your money? Think about it. Let us say another business person have urge you enter in their business of selling ready to wear clothes rather than invest you money in the bank which only offers a risk free but a low 4% interest rate. This business person says he will give you a 10% interest if you invest your money in his business. You may thought about the weak sales is a risk on your part and so it maybe since the sales of a ready to wear clothing may vary from time to time this person may not be able to pay you in time so there is a slight risk in your savings. But then again you may think about the 10% offer which is more than double of 4% interest in bank offer. A slight risk is there and you may think about it deeper if you are going to accept the businessman’s proposal.
Now, another business person has offer a partnership of a new business let us say you are going to engage in a computer shop business. This business offers you 30% shares of over all income if you are going to invest your money in his newly constructed computer shop. You may think about the risk of its sale, you may wonder if he will find a good location in his business or will he ever earn since he is new to the market. The big risk is there but a good earning potential also exist. Would you accept his offer?
And so you have 3 offers on your part at hand and this are the following:
1. Bank at 4% risk free
2. Ready to wear business at 10% medium risk or systematic risk
3. New computer shop at 30% high risk
What offer will you accept is up to you. Let us go back to the Capital Asset Pricing Model and let us represent the following it its use, let say you are looking for an equity represented by equity=Ke and the bank offer is risk free = Rf and the market rate is =Rm and β= medium risk or systematic risk. We can derive the following formula:
Ke= Rf + β (Rm-Rf) Since we are just talking about the theory we are not going to dig into the deeper computation of the following but you already have in your mind the idea of the system. And this is just one example of a formula using the theory of Capital Asset Pricing Model, from this point of view we can easily determine what lost or gain we can derive from the recent three offers. This model is used as a tool to determine if an asset or investment will give us a reasonable expected return or risk. From the following example we can say that the Capital Asset Pricing Model is a very satisfactory theory that will give us an advance and updated knowledge to be wise in making decisions in making a good investment.
Credit:ivythesis.typepad.com
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