Finance Assignment CAPM
“Critically discuss whether the CAPM makes portfolio theory redundant.”
Introduction
This assignment will explore whether CAPM makes portfolio theory redundant. The following areas will be discussed; Stages involved, functions and roles, important components, formula of cap-M, positive and negative aspects of Cap-M, all while drawing to the conclusion to whether Cap-M makes portfolio theory redundant. (ref:2)
Definition
CAPM is defined as Capital asset pricing model. It is an economic theory and is used in Finance to determine a theoretically appropriate rate of return of an asset. It is a model that describes the relationship between risk and expected return. 2,5 CAPM can be used when pricing the risk of securities. It is the expected return of a security or a portfolio which equals the rate on a risk-free security along with a risk premium. The CAPM was introduced independently by Jack Treynor (1961, 1962),[2] William Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966), who were building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. (Ref: 1,2,5)
Formula
As already stated above, CAPM is a model for pricing an individual security or portfolio. When looking at individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class.(Ref: 2,5,6). The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:
The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the capital asset pricing model (CAPM).
Introduction
This assignment will explore whether CAPM makes portfolio theory redundant. The following areas will be discussed; Stages involved, functions and roles, important components, formula of cap-M, positive and negative aspects of Cap-M, all while drawing to the conclusion to whether Cap-M makes portfolio theory redundant. (ref:2)
Definition
CAPM is defined as Capital asset pricing model. It is an economic theory and is used in Finance to determine a theoretically appropriate rate of return of an asset. It is a model that describes the relationship between risk and expected return. 2,5 CAPM can be used when pricing the risk of securities. It is the expected return of a security or a portfolio which equals the rate on a risk-free security along with a risk premium. The CAPM was introduced independently by Jack Treynor (1961, 1962),[2] William Sharpe (1964), John Lintner (1965a,b) and Jan Mossin (1966), who were building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. (Ref: 1,2,5)
Formula
As already stated above, CAPM is a model for pricing an individual security or portfolio. When looking at individual securities, we make use of the security market line (SML) and its relation to expected return and systematic risk (beta) to show how the market must price individual securities in relation to their security risk class.(Ref: 2,5,6). The SML enables us to calculate the reward-to-risk ratio for any security in relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:
The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(Ri), we obtain the capital asset pricing model (CAPM).
References: 1. Portfolio Theory and the CAPM: Theory and Tests. By Jiro E. Kondo 2. Slide share 3. Investopedia 4. Financial Management: An Irish text. Thomas Power, Stephen Walsh, Paul O 'Meara, Gill & MacMillan, Limited, 2005 5. Practical Financial Management, Colin Barrow, Eight Edition. 6. Financial Management: A practical approach. By William Lasher. International Edition.