The Capital Asset Pricing model and its successorsuseful or useless?

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.(INVESTOPEDIA, 2011).The CAPM is an important area of financial management. In fact, it has even been suggested that finance only became a fully-fledged, scientific discipline when William Sharpe published his derivation of the CAPM in 19861. ( Megginson W L, p10, 1996.)It is based on linear relationship between the return required on an investment (whether in stock market securities or in business operations) and its systematic risk is represented by the CAPM formula E(ri) = Rf + i(E(rm) - Rf)

E(ri) = return required on financial asset i Rf = risk-free rate of return i = beta value for financial asset i E(rm) = average return on the capital market Rather than finding the average return on the capital market, E(rm), research has concentrated on finding an appropriate value for (E(rm) - Rf), which is the difference between the average return on the capital market and the risk-free rate of return. This difference is called the equity risk premium, since it represents the extra return required for investing in equity (shares on the capital market as a whole) rather than investing in risk-free assets. In order to understand the CAPM It is useful to look into systematic and unsystematic risk. If an investor has a portfolio of investments in the shares of a number of different companies, it might be thought that the risk of the portfolio would be the average of the risks of the individual investments. In fact, it has been found that the risk of the portfolio is less than the average of the risks of the individual investments. By diversifying investments in a portfolio, therefore, an investor can reduce the overall level of risk faced. There is a limit to this risk reduction effect, however, so that even a fully diversified portfolio will not eliminate risk entirely. The risk which cannot be eliminated by portfolio diversification is called undiversifiable risk or systematic risk, since it is the risk that is associated with the financial system. The risk which can be eliminated by portfolio diversification is called diversifiable risk, unsystematic risk, or specific risk, since it is the risk that is associated with individual companies and the shares they have issued. The sum of systematic risk and unsystematic risk is called total risk (Watson D and Head A, 2006, p213). CAPM is useful in respect it emphasizes the effect of undiversifiable or systematic risk on investors required rate of return.It assumes that market returns on securities relate only to the market index and the other determinants of returns are unique to the individual company and thus diversifiable.(J. E. Broyles, 2003, p240).Investors hold diversified portfolios, Single-period transaction horizon, Investors can borrow and lend at the risk-free rate of return, and Perfect capital market are the underlying assumptions of CAPM.CAPM is often criticized as being based on unrealistic assumptions.(Watson D and Head A, 2007, p222230).This model could be too simple and additional indices might help to explain security returns.APT (ARBITRAGE PRICICING THEORY) has been presented as a potential successor to the CAPM.Arbitrage pricing Theory is another way of attempting to minimize risk and involves simultaneously buying and selling different assets that have highly correlated returns (J. E. Broyles, 2003, p241).It does not require the existence of an efficiently diversified portfolio. As a result it can make use of more than one index to explain returns. Its formula is E(ri)= Rf + 1 x (factor 1) + 2 x (factor 2)... + n x (factor n)

Where:

= the sensitivity of the stock to each factor factor = the risk premium associated with each factor

APT is similar to CAPM except it has more explanatory variables with a different Beta for each. The APT model is different from the CAPM in that it is far less restrictive in its assumptions such as holding well diversified portfolio which is often criticized for CAPM. APT allows the individual investor more freedom to develop a model that explains the expected return for a particular asset(Money-zine, 2011).After more than two decades , however, use of the CAPM appears to be more frequent than the APT for estimating expected rates of return for individual assets such as individual company shares or capital projects( E.J. Elton, MJ. Gruber,J. Mei, 1994).

BIBLIOGRAPHY http://www.investopedia.com/terms/c/capm.asp#ixzz1ggvNitNp http://www.investopedia.com/terms/a/apt.asp#ixzz1gh95llXv Megginson W L, Corporate Finance Theory, Addison-Wesley, p10, 1996. Watson D and Head A, Corporate Finance: Principles and Practice, Financial Times/Prentice Hall, 2006, p213, p222230 J. E. Broyles, Financial management and real options, John Wiley and Sons, 27-Jan-2003, p240. E.J. Elton, MJ. Gruber, J. Mei, 1994, Cost of Capital using arbitration pricing theory; A case study of nine New York utilities, Financial Markets, Institutions and Instruments, Vol. 43(Feb), p46-73 http://www.money-zine.com/Investing/Stocks/Arbitrage-Pricing-Theory-or-APT/