27-11-2012, 01:04 PM
Capital Asset Pricing Model $ Portfolio Revision Techniques
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CAPITAL MARKET THEORY
Capital Market Theory incorporates a relationship explaining how assets should be priced in capital market.
The investments market is a very complex market.
Any model or theory which deals with pricing of assets, must remove these complexities. A few asset market complexities are commissions, taxes, short selling rules, margin requirements etc.
Assumptions of Capital Market Theory are unrealistic and do not hold good in real world.
CAPITAL ASSET PRICING MODEL
According to CAPM Model developed by William F. Sharpe, each portfolio is combination of systematic and unsystematic risks.
Systematic risk attached to each security is same irrespective of any number of securities.
The total risk is reduced with increase in number of stock.
Explains Pricing of Assets in Capital Market
According to CAPM all investors hold only the market portfolio and riskless securities. The market portfolio is a portfolio comprised of all stocks in the market. Each asset held in proportion to its market value to the total value of all risky assets.
ASSUMPTIONS :
An individual seller or buyer cannot affect the price of a stock. This the basic assumption is that it is a perfectly competitive market.
Investors make their decisions only on the basis of the expected returns i.e. standard deviations and covariance of all pairs of securities.
Investors are assumed to have homogenous expectations during the decision making period.
The investor can lend or borrow any amount of fund at the risk-less rate of interest. The risk-less rate of interest is the rate of interest offered for the treasury bills or Government securities.
Assets are infinitely divisible. According to this assumption, investor could buy any quantity of share i.e. they can even buy ten rupees worth of Reliance Industry shares.
There is no transaction cost i.e. no cost involved in buying and selling of stocks.
There is no personal income tax. Hence, the investor is indifferent to the form of return either capital gain or dividend.
Unlimited quantum of short sales, is allowed. Any amount of shares an individual can sell short.
VALIDITY OF CAPM
The CAPM focuses on the market risk.
The CAPM has been useful in the selection of securities and portfolios.
In the CAPM, it has been assumed that investors consider only the market risk. Given the estimate of the risk free rate, the beta of the firm, stock and the required market rate of return, one can find out the expected returns for a firm’s security. This expected return can be used as an estimate of the cost of retained earnings.
Even though CAPM has been regarded as a useful tool to financial analysts. Empirical tests and analyses have used ex- post i.e. past data only.
The historical data regarding the market return, risk free rate of return and betas vary differently for different periods.
CAPM Model - Conclusion
The CAPM model is based on specific assumptions. The investor could borrow or lend any amount of money at risk-less rate of interest.
All investors hold only the market portfolio and the risk-less securities.
Market portfolio consists of the investments in all securities of the market. The proportion invested in each security is equal to the percentage of the total market capitalisation represented by the security.
The capital market line represents the relationship between the expected return and the standard deviation of the portfolio.
The risk of the security is indicated by its covariance with the market portfolio.