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What is the Capital Asset Pricing Model?

March 16th, 2003, 8:31 pm

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Last edited by Paul on March 15th, 2003, 11:00 pm, edited 1 time in total.
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What is the Capital Asset Pricing Model?

March 16th, 2003, 9:03 pm

Developed by W. Sharpe and considered to be one of the definitive models (though i am sure some would debate) of calculating risk and return. Unlike, for example the Black-Scholes or Binomial model for pricing of derivatives on a relative basis, the CAPM values derivatives and assets alike in an absolute basis, based on several inputs:Risk Free Rate (Riskless Return)Market Risk Premium (Market Return - Risk Free Rate)Beta (which refers to the systematic [non-diversifiable] risk within a security)To come up with a formula:Expected Return = Riskless Return + Beta (Market Risk Premium)
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What is the Capital Asset Pricing Model?

March 18th, 2003, 3:45 pm

Sharpe developed a notion of investment risk and reward, a sophisticated reasoning that has become known as the Capital Asset Pricing Model, or CAPM.Sharpe's role in developing the CAPM was recognized by the Nobel Prize committee. Sharpe shared the Nobel Memorial Prize in Economic Sciences that year with Markowitz and Merton Miller.According to CAPM every investment carries two distinct risks, the CAPM explains. One is the risk of being in the market, which Sharpe called systematic risk. This risk, later dubbed "beta," cannot be diversified away. The other—unsystematic risk—is specific to a company's fortunes. Since this uncertainty can be mitigated through appropriate diversification, Sharpe figured that a portfolio's expected return hinges solely on its beta—its relationship to the overall market. The CAPM helps measure portfolio risk and the return an investor can expect for taking that risk. Risk is the key variable. has the CAPM a validity nowadays? Is beta useful? Beta is really focused on whether or not individual stocks have higher expected returns if they have higher betas relative to the market. It would be irresponsible to assume that is not true. That doesn't mean we can confirm the data. We don't see expected returns; we see realized returns. We don't see ex-ante measures of beta; we see realized beta.Real doubt is, does beta correctly expresses correlation of firm returns with market returns and, more precisely, may I select a beta for sectors-ASA, and how distinguish systematic versus unsystematic risk components? Thanks for your answers.
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What is the Capital Asset Pricing Model?

March 19th, 2003, 2:27 am

Markowitz and Sharpe are far smarter than I can even comprehend. I mean them no disrespect. The CAPM, however,is nothing more than a philosophical abstraction. Who could disagree with the notion that investors should rank investments on an efficient frontier using historical return divided by the standard deviation of return as a measure of relative suitability for investing?Unfortunately, the CAPM is virtually irrelevant for investment decision making, as there is almost no stability of these relationships over time. Sharpe stated as much in a recent interview with risk magazine. Markets always react the same way to similar perceived risks. I don't think there is any empirical evidence to justify the notion that future asset return distributions will follow past patterns.