CapitalAsset Pricing Model (CAPM)

CapitalAsset Pricing Model (CAPM)

Fromthe video, Prof. Robert Townsend tries to analyze the best possibleresearch methods as well as the notion of studying the risk andreturn in village households. It is worth noting that, the CapitalAsset Pricing Model (CAPM) predicts that the projected return ofasset’s return over the risk-free rate has a linear correlationwith the non-diversifiable risk as determined by the asset’s beta.The model has been widely tested by different authors across variouscountries to determine the return of the stock, and Prof. RobertTownsend has provided an explanation on how to determine the rate ofreturn in village households. On other hand, you cannot estimate thereturns without projecting or analyzing the risk. Risks constitute asignificant part of any investment. However, it is apparent thathowever much a business will try to diversify its operations, it isalways not possible for it to counter all the risks it is likely toencounter during its operations. It is worth noting that in most ofthe investors anticipate higher returns from the riskier investments.Therefore, it is necessary to have a rate of return that will helpthe business compensate on the risks it encounters especially onvillage household. It is from such an idea that the Capital AssetPricing Model (CAPM) was developed. In addition, the model intends tohelp village household in calculating the investment risk togetherwith the return on investment. It is worth noting that, CAPM wasdeveloped by Sharpe in 1964, but it was later modified by Lintner in1965 and Black in 1972. Since its development, its impact,particularly to the financial community, has been significant overthe decades, and this is why the development of CAMP is consideredtoday as to have marked the origin of the Asset Pricing Models.

Fromthe video, the main prediction of CAMP is that a market portfolio ofthe total amount of wealth invested is the mean-variance efficientthat leads to a linear cross-sectional correlation between the marketexposures factor and the mean excess returns. This model is basicallyinspired by the portfolio theory that was established by HarryMarkowitz in 1959. In addition, it is worth mentioning that like anyother model, the Capital Asset Pricing Model is based on variousassumptions. The basic assumption behind the Capital Asset PricingModel as describe from the video is that a linear correlation existsbetween the projected return on a risky asset and thenon-diversifiable risks, which is determined by the asset’s beta.Into the bargain, the model assumes that beta is a sufficient and anapplicable measure of risks that are determined by a cross section ofthe assets average returns, which, therefore, imply that assets canattain a high average return only when there is a high market beta.From Prof. Robert Townsend, beta drives average returns determine howmuch the addition of the extra stock to a more diversified portfolioenhances the intrinsic risk along with the portfolio’s volatility.Despite the fact that correlations that have been brought forward bythe Capital Asset Pricing Model are the basis of many empiricalstudies, it is worth noting that several studies have highlighted thesignificance of this finance model, while others have disapproved itsrelevance. He also highlight that this model offers powerful andpleasing predictions regarding the risk measurement together with thecorrelations between the anticipated return and risk.

Howdoes the topic fit into your development and knowledge of financeand economics?

Thisvideo contains the basic element required to form a strong foundationin studying finance as well as the economics. Prof.Robert Townsend provides various formulas, which are very useful indetermining the rate of return in village household. Personally, Iwill also apply the same formulas as well as the logic provided byProf. Robert Townsend in my future studies. In addition, by watchingthe video, it creates interest as well ‘passion in studyingeconomics and finance. On other hand, The Capital Asset Pricing Modelis a powerful financial analysis tool in as much as it lays the mostsound investment return formula. Many other investment models arebuilt upon it. However, its assumptions render its resultssignificantly erroneous in many instances where market dynamics areposing more dimensions of risk than those traditionally associatedwith a perfectly predictable market. It would, therefore, bebeneficial, in order to achieve more precise results, to introduceprovisions that make for other unpredicted variables in theinvestment arrangements, such as the multi-variables consideration inthe Arbitrage Pricing Model. In obtaining the beta value for theexpected return rate for instance, APT model would consider morevariables than CAPM which relies only on leverage and two marketderived constants a and b. This would realize a more sensitive betacoefficient, which would show more sensitivity to different marketconditions.

References

Townsend,R. (n.d). *CapitalAsset Pricing*.Retrieved From,__http://ocw.mit.edu/courses/economics/14-772-development-economics-macroeconomics-spring-2013/lecture-videos-and-slides/lecture-7-february-28-2013/__