The article below talks about CAPM and the formula. Still have issues understanding CAPM? SMS +65 9758-7925 or email enquiry@starcresto.com for tuition!
CAPM: ASSUMPTIONS
Capital asset pricing model assumes that in an open market place, all investors are well-diversified and with homogenous belief, they hold on to the same risky assets. Additionally, there is a risk-free asset where the lending and borrowing rate is the same at rf and there is unlimited amount of capital that are available. Also, it is assumed that the market has perfect information and that all investors are rational and risk averse.
CAPM Illustration
Given the assumptions, it meant that everyone has the same assets to choose from, the same information about the assets and same decision methodology (from Markowitz mean-variance portfolio theory). Thus, everyone would be choosing a portfolio on the same efficient frontier with a mixture of risk-free asset and risky assets (M). That is, everyone sets up the same optimization problem, does the
same calculation, gets the same answer and chooses a portfolio accordingly.
Since everyone is holding on to the same, risky assets portfolio, that is also known as market portfolio. Also, the fact that the investors are well diversified implies that they do not look at standard deviation which measures total risk but only on systematic risk (non-diversifiable risk) which is measured by beta. Hence, CAPM formula can be presented by
ri = rf + βi(rM − rf)
where
1. ri --> required rate of return for the ith stock
2. rf --> risk free rate
3. βi --> beta of the ith stock
4. rM --> return of an average stock / market index
5. (rM − rf) --> market risk premium
6. βi(rM − rf) --> risk premium
(C) Valerie Chai Hui Yee, 2014, Capital Asset Pricing Model
To cite the work, please request for permission by sending an email to val@starcresto.com
For more information, visit www.tuition.starcresto.com
No comments:
Post a Comment
Note: Only a member of this blog may post a comment.