Capital Asset Pricing Model (Capm)
Introduction
Capital asset pricing has always been an active area in the finance literature. Capital Asset Pricing Model (CAPM) is one of the economic models used to determine the market price for risk and the appropriate measure of risk for a single asset. The CAPM shows that the equilibrium rates of return on all risky assets are function of their covariance with the market portfolio. This theory helps us understand why expected returns change through time. Furthermore, this model is developed in a hypothetical world with many assumptions.
The Sharp-Lintner-Black CAPM states that the expected return of any capital asset is proportional to its systematic risk measured by the beta. (Iqbal and Brooks, 2007). Based on some simplifying assumptions the CAPM is expressed as a linear function of a risk free rate, beta and the expected risk premium. An important quantity required for decisions on evaluating public and private funded projects is an appropriate cost of capital. This discount rate is often estimated by a model of expected return. The CAPM has been extensively employed for estimating cost of capital and evaluating the performance of managed funds.
Various studies had been performed by various researchers on the capital asset pricing model in different type of markets across the countries around the world. Some of the studies manage to prove that there was a strong relationship between risk and return, while some of them conclude that there is actually no significant relationship between risk and return. However, it was the differences of the market that were tested that resulted in the various different results.
There are two fundamental hypotheses of the CAPM that will be discussed in this study. First is the linearity of the risk-return relationship and second is that beta is the only relevant risk variable explaining cross section variation in expected returns.
In this paper, empirical test are performed to test the explanatory performance of
Capital asset pricing has always been an active area in the finance literature. Capital Asset Pricing Model (CAPM) is one of the economic models used to determine the market price for risk and the appropriate measure of risk for a single asset. The CAPM shows that the equilibrium rates of return on all risky assets are function of their covariance with the market portfolio. This theory helps us understand why expected returns change through time. Furthermore, this model is developed in a hypothetical world with many assumptions.
The Sharp-Lintner-Black CAPM states that the expected return of any capital asset is proportional to its systematic risk measured by the beta. (Iqbal and Brooks, 2007). Based on some simplifying assumptions the CAPM is expressed as a linear function of a risk free rate, beta and the expected risk premium. An important quantity required for decisions on evaluating public and private funded projects is an appropriate cost of capital. This discount rate is often estimated by a model of expected return. The CAPM has been extensively employed for estimating cost of capital and evaluating the performance of managed funds.
Various studies had been performed by various researchers on the capital asset pricing model in different type of markets across the countries around the world. Some of the studies manage to prove that there was a strong relationship between risk and return, while some of them conclude that there is actually no significant relationship between risk and return. However, it was the differences of the market that were tested that resulted in the various different results.
There are two fundamental hypotheses of the CAPM that will be discussed in this study. First is the linearity of the risk-return relationship and second is that beta is the only relevant risk variable explaining cross section variation in expected returns.
In this paper, empirical test are performed to test the explanatory performance of
References: Iqbal, J., & Brooks, R. (2007). A Test of CAPM on the Karachi Stock Exchange. International Journal of Business, 12(4), 429-444. Gunnlaugsson, S.B. (2006). A Test of CAPM on a Small Stock Market. The Business Review, Cambridge, 6(1), 292-296. Pai, A., & Geltner, D. (2007). Stocks Are From Mars, Real Estate Is From Venus. Journal of Portfolio Management, 134-144. Guan, L., Hansen, D.R., Leikam, S.L., Shaw, J. (2007). Stable betas, earnings-to-price, book-to-market and the validity of the capital asset pricing model. Managerial Finance, 33(8), 595-614. Guo, H. (2006). The Risk-Return Relation in International Stock Markets. The Financial Review, 41, 565-587.