The Capital asset pricing model (CAPM) is a very useful model and it Essay

The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the industry even though it is based on v - Essay Example In this sense, a high quantity of a security’s beta would result in a high expected return of an asset and vice versa. After CAPM was published, and after actual returns were compared with expected returns, many economists have since then criticized the simplicity of and the reality of application of CAPM. The CAPM is still subject to empirical and theoretical criticism despite it being the basis for over a hundred academic papers and having affected non-academic fiscal community considerably. Although it has an apparent invalidity, the CAPM is still widely used by companies as a valuable model for computation of capital cost through justification of high returns in correspondence to higher beta. Therefore, this paper will discuss the implications with regards to the current developments in the area. The paper will first explain and discuss various assumptions in relation to the model and thereafter discuss the key theories as well as the whole debate that surround this area p articularly through the criticizing the assumptions. There are numerous economic applications of the CAPM. It is used in valuation of a company’s common stock, for acquisition and merger analysis, capital budgeting and the valuation of convertible and warrants securities (Naylor & Tapon 1982, p.1166). To ensure validity of the CAPM, William Sharpe came up with numerous assumptions designed for investors in the creation of market equilibrium. The supporters of the model postulate that the capital market functions as though the above assumptions were met. The model derives the price to be commanded by any asset to make the investors happy to retain the present market portfolio. Under the CAPM, each person carries similar risk in diverse amounts. Investors have different portfolios, and they will need a return for their portfolio’s systematic risk because the removal of the unsystematic risk has been done and therefore, can be disregarded. An investor will give a ranking to the portfolio in accordance with a utility function which is dependent on the expected return rate of this portfolio. Because everyone has the same risky assets’ portfolio; it is normal that everyone is exactly happy to purchase the market portfolio, that is, the portfolio of every asset available in the market. Furthermore, part of the risk can be diversified through purchasing many dissimilar assets. The level of stock risk not necessarily related to how variable its return is. The variability is an appropriate measure only if one investor invests all his/her money in one asset. In reality, part of the risk is diversified through purchasing many dissimilar assets. In fact, through diversification, there is a possibility of averting the risk associated with each stock as opposed to the risk which the whole market may decline. The non-diversifiable risk originates form macroeconomic factors which affect all assets simultaneously. For instance, in the credit-crunch many fir ms have the tendency of having negative cash flows and low profits. As much as the assumptions contained in CAPM permit it to concentrate on the relationship between systematic and return risk, they propose an idealized world that is different from the real world where investment decisions are majorly made by firms