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What is the CAPM(Capital Asset Pricing Model) how it is useful ?

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Question ajoutée par venkaramanujam subramanian , Acccounts Manager , CHRONOLOGY M/s Subramanian Associates Practising Chartered Accountants
Date de publication: 2016/10/20
Muhammad Ahsan Ali
par Muhammad Ahsan Ali , Assistant Director , University of education Lahore

This model is useful when the securities market is assessed in relation to the risk free return offered and the specific risk associated to the security

Haider Tareen ACCA
par Haider Tareen ACCA , Finance Manager , ARABIAN SANDS REAL ESTATE LLC

Before explaining im assuming you have knowledge of Risk and diversification

 

The capital asset pricing model (CAPM) is a model that describes the relationship between systematic risk and expected return for assets, particularly market,

Systematic Risk that relates to the industry and represent as Beta Equity

it is uncertain risk and cannot be avoided by all companies for a specific industry e.g FMCG Industry

systematic risk consists of the day-to-day fluctuation of transaction or return or share price in the market for all distributors in particular FMCG Market

If day-to-day fluctuation of transaction are high it means market is booming and vice versa

Systematic Risk is useful to calculate if you have debt facility by Bank or any investor since the company needs to pay the interest with principal amount.

You can see the formula of calculating the systematic risk in google

 

After you get the systematic risk of a particular industry based on the industry Debt and Equity values, Beta Asset Value, Risk Premium Value, you can find the Cost of equity which is known as CAMP for your FMCG Company and based on that CAMP you can calculate the WACC to reflect the accurate Net Present Value of your future cash flows or Capital Budgeting values.

 

Note you must also check the BSOP model to calculate the value of company based on industry risk and return

 

 

Problem with CAMP

The model assumes that the variance of returns is an adequate measurement of risk. This would be implied by the assumption that returns are normally distributed, or indeed are distributed in any two-parameter way, but for general return distributions other risk measures (like coherent risk measures) will reflect the active and potential shareholders' preferences more adequately. Indeed, risk in financial investments is not variance in itself, rather it is the probability of losing: it is asymmetric in nature.

The model assumes that all active and potential shareholders have access to the same information and agree about the risk and expected return of all assets (homogeneous expectations assumption)

The model assumes that the probability beliefs of active and potential shareholders match the true distribution of returns. A different possibility is that active and potential shareholders' expectations are biased, causing market prices to be informationally inefficient. This possibility is studied in the field of behavioral finance, which uses psychological assumptions to provide alternatives to the CAPM such as the overconfidence-based asset pricing model of Kent Daniel

The model does not appear to adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict. Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves the efficient-market hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but makes the EMH wrong – indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market)

The model assumes that given a certain expected return, active and potential shareholders will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones. It does not allow for active and potential shareholders who will accept lower returns for higher risk. Casino gamblers pay to take on more risk, and it is possible that some stock traders will pay for risk as well

 

The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed with more complicated versions of the model

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