The Redundant Capital Asset Pricing Model
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This paper examines how the capital asset pricing model (CAPM)is a tool to calculate the required rate of return for a security. It takes into account the return that an investor can earn on risk free security (usually government T-Bills), risk premium (difference between the return on risk free investment and return on investment in market) and beta. In particular, the paper discusses why the model has become redundant and outdated because of its invalid nature and its inability to take into account the transaction costs and taxes that are prevalent in the system and distort the actual or real required rate of return demanded by an investor.
From the Paper:"Another weakness of model lies in the fact that it fails to recognize the prevalence on non-diversifiable systematic risks in the markets. These risks are experienced by even the most generalized portfolios that reflect the market returns. Another thing that should be kept in mind here is the fact that there is no risk free investment in the market (McAdams and Kariagannis, 1994 pp. 57-60). All types of investments face certain types of risk no matter how safe they look. Even in the case of T-Bills and government securities, the reinvestment risk is always there and since it cannot be eliminated therefore there is no risk free investment. The model also assumes that the risk premium will be higher for stocks which have a beta of 2.0 and half for the stocks which have a beta of 0.5. This is no true in some cases. Risk premium does not only differ on the basis of risk profile of stock. Risk premium also differs because of the liquidity premium that is offered by some stock because they are very easy to buy and sell. "
Sample of Sources Used:
- Brigham, E. and Ernhardt, M. (2004) Fundamental of Financial Management. 4th ed. New York: South-Western Publisher, p.432-435.
- Eun, C. (1994) The Benchmark Beta, CAPM, and Pricing Anomalies. Oxford Economics Papers, 46 (2), p.345-350.
- Fama, E. and French, K. (2006) The Value Premium and the CAPM. The Journal of Finance, 61 (5), p.2163-2185.
- Forbes.com (2012) CAPM: The First Factor of Investing - Forbes. [online] Available at: http://www.forbes.com/sites/davidmarotta/2012/03/19/capm-the-first-factor-of-investing/ [Accessed: 19 Apr 2012].
- Harris, R. (1980) A General Equilibrium Analysis of the Capital Asset Pricing Mode. Journal of Financial and Quantitative Analysis, 15 (1), p.99-122.
Cite this Term Paper:
The Redundant Capital Asset Pricing Model (2012, November 30) Retrieved January 29, 2020, from https://www.academon.com/term-paper/the-redundant-capital-asset-pricing-model-152072/
"The Redundant Capital Asset Pricing Model" 30 November 2012. Web. 29 January. 2020. <https://www.academon.com/term-paper/the-redundant-capital-asset-pricing-model-152072/>