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Critically evaluate the use of “Beta” and CAPM by a fund manager to select the shares to be purchased.
Introduction.
In financial sector, a fundamental question for any fund manager is how to estimate correctly their equity investment. The Capital Asset Pricing Model (CAPM) and Beta can be used to provide comprehensible answer for this question. According to the earlier study of Markowitz (1952), Sharp (1964), Lintner (1965) and Mossin (1966) have developed CAPM as a key portfolio management model that referring to the relationship between expected return and risks of assets. Based on the CAPM, the return of the portfolio consists of two components such as: the risk-free rate of return and the compensation for taking on risk. The risk-free rate is a rate of return of safe investment (i.e. government bond or 1 year-Treasury bill). The compensation or excess return on equity depends on two things: (i) a measurement of the portfolios risk Beta, and (ii) the market risk premium. Specially, beta is the key components of CAPM. It is a risk measurement, introducing the extent to which the sensitivity of a single security’s return responds to variation in return of stock market.
By using effective CAPM and Beta, the investment managers can achieve a higher return for a specified acceptable level of risk. Nonetheless, there are several debates about the usefulness of CAPM. Therefore, the first and second part of this essay will focus on exploring the advantages of using CAPM and Beta to help fund manager obtain optimal asset portfolios and the underlying problems of the model respectively. Finally, after in-depth analysis of the key problems of the CAPM, the possible solutions to overcome such shortfalls of the CAPM will be made. 1. The advantages of Beta and CAPM
According to Bodie et al 2011, Brealey et al 2011, Fama and MacBeth (1973) , the CAPM play a particularly important role in assessing security portfolios in term of mean-variance preferences. There are
Introduction.
In financial sector, a fundamental question for any fund manager is how to estimate correctly their equity investment. The Capital Asset Pricing Model (CAPM) and Beta can be used to provide comprehensible answer for this question. According to the earlier study of Markowitz (1952), Sharp (1964), Lintner (1965) and Mossin (1966) have developed CAPM as a key portfolio management model that referring to the relationship between expected return and risks of assets. Based on the CAPM, the return of the portfolio consists of two components such as: the risk-free rate of return and the compensation for taking on risk. The risk-free rate is a rate of return of safe investment (i.e. government bond or 1 year-Treasury bill). The compensation or excess return on equity depends on two things: (i) a measurement of the portfolios risk Beta, and (ii) the market risk premium. Specially, beta is the key components of CAPM. It is a risk measurement, introducing the extent to which the sensitivity of a single security’s return responds to variation in return of stock market.
By using effective CAPM and Beta, the investment managers can achieve a higher return for a specified acceptable level of risk. Nonetheless, there are several debates about the usefulness of CAPM. Therefore, the first and second part of this essay will focus on exploring the advantages of using CAPM and Beta to help fund manager obtain optimal asset portfolios and the underlying problems of the model respectively. Finally, after in-depth analysis of the key problems of the CAPM, the possible solutions to overcome such shortfalls of the CAPM will be made. 1. The advantages of Beta and CAPM
According to Bodie et al 2011, Brealey et al 2011, Fama and MacBeth (1973) , the CAPM play a particularly important role in assessing security portfolios in term of mean-variance preferences. There are
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