In such a time, this model gives you the decisiveness for diversification of the assets in your portfolio. Whereas, this model assumes that there are particular kinds of financial assets which may be available with zero risk on returns. Some examples of such a diversified risk are wars, recession, etc. Now, systematic risk is that amount of risk which you may bear on a specific investment in the market. Other Factor Models of Asset Pricing CAPM and its WorkingĬapital Asset Pricing Model is quite a useful one which helps you get a fair understanding of the relationship between the estimated return on an investment and its risk or systematic risk.Two Primary Benefits and Two Limitations of the Model.How do you calculate Beta and what is the Capital-Security Market Line?.Apart from this model, there are other models as well which we will discuss for Asset Pricing.
Yet, there are other concepts that surround the model which this article has covered.įurthermore, in the same model, calculation of risk is essential for getting the right estimate of return or premium on that risk. This relationship between risk and premium gained for bearing the risk is the core of CAPM. It takes into account several assumptions and shows how the risk of investing in a particular asset defines the amount of return the investor will gain out of it. This model focuses on the sensitivity of the asset’s rate of return to the presence of a risk which befalls the entire stock market and is known as systematic risk. This model was developed by Sharpe and Lintner, and it is mainly for this work that Sharpe won the Nobel Laureate in 1990.Having its origin in 1964, CAPM or Capital Asset Pricing Model is an extremely relevant part of financial management and is an easy model to understand as well as apply. The answers to the first five questions facilitate the analysis corresponding to the sixth question, the one that constitutes the core of this chapter, where an equilibrium pricing model is derived, well known as the CAPM. What is the risk index of an individual asset when many other risky assets are held with the asset under consideration in the same portfolio? What is the risk index of the portfolio in such a case?Įmploying the M-V rule and adding some additional assumptions regarding the efficiency of the market, what are the implied equilibrium prices of the various risky assets? What is the risk return equilibrium relation? What is the risk index of an asset when only one risky asset is held in the portfolio? Which economic factor determines how one should diversify between the risky asset and the riskless asset? What is the optimal diversification strategy in risky assets when unlimited borrowing and lending at the risk-free asset prevail? Does it vary across investors? What is the optimal portfolio diversification strategy when only risky assets are available in the markets? Does the optimal choice vary across investors? In this chapter, we assume that investors make their portfolio choices by the M-V rule and investigate the implication of the M-V portfolio selection framework to several issues, issues that pave the way to the development of the CAPM: Moreover, the CAPM assumes that investors make investment decisions by the M-V rule and is based on the M-V efficiency analysis.
The analysis of the validity of the M-V analysis is of crucial importance because the M-V framework is the foundation of the Capital Asset Pricing Model (CAPM), to which we devote a substantial part of this book. We also demonstrated cases where the M-V rule is not allowed to be employed because it may yield paradoxical results.
In the preceding chapters, we have discussed the theoretical foundations of the Mean-Variance (M-V) rule and analyzed the conditions under which one can safely employ this rule.