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Complete 9 page APA formatted essay: What Is The CAPM (Capital Asset Pricing Model) And Of What Practical Use Is It Investment Risk And Return: Concept Analysis.Download file to see previous pages...
Complete 9 page APA formatted essay: What Is The CAPM (Capital Asset Pricing Model) And Of What Practical Use Is It Investment Risk And Return: Concept Analysis.
Download file to see previous pages...On September 28, 2008 CNN reported, “The day's loss knocked out approximately $1.2 trillion in market value, the first post-$1 trillion day ever (CNN Money 2008 p. 1).” The above facts explain that investment in the security market is associated with the risk. sometime its magnitude is no less than the worst volcanic eruption or earthquake. The consequences of financial crashes create enormous damage in individuals’ plus country’s economic condition. Nevertheless, people keep investing in the security market. The primary reason is the opportunity of getting a good return from the security market. For example, during 1992 – 2011, the average of returns of the S&.P was 9.6 % (Forbes 2012). Regardless of stock market crashes many investors believe that leaving money in the high-yield saving accounts is not an investment at all. Nevertheless, investing money in the security market involves a significant amount of risks. The return of an investment is a function of risks. lower the risks lower the return, and higher the risks higher the return. Return and risk relationship at the conceptual level can be represented through a straight line shown in figure 1.An investment may encounter market risk, default risk, interest rate risks, liquidity risk, and political risks (Forbes 2012). These risks make an impact on the return of an investment. The capital asset pricing model studies the impact of risks on the return of an investment....
Investment instrument is an asset that can be can be bought and sold (Washington.edu n.d.). Markowitz also developed the concept of security portfolio. William Sharpe and John Lintner are the authors of the capital asset pricing model (CAPM). the model is based on the asset-pricing theory (Fama &. French 2004), and Markowitz’s portfolio selection concept. Morkowitz model assumed that all investors were risk averse, and they chose mean variance efficient portfolios (Washington.edu n.d.). That is why. his approach is called mean variance model. Sharpe added two assumptions to this model to determine a mean-variance efficient portfolio from the security market. To understand the concept of mean-variance efficient portfolio, first we need to understand the concept of capital market line (CML). We use the graphical display of figure 1 to demonstrate the CML concept. We change the x-y axis plane to ? – E (r) plane. Figure 2. CML equation, E (r i) = r f + [{E(rM ) – rf } / ?M] x ? (Fama &. French 2004). The axis ? is the level of risk or standard deviation of the portfolio, and E (r) is the expected return of the portfolio. The equation y = a + mx is changed according to the new coordinate system and expressed as E (r i) = r f + [{E(rM) – rf } / ?M] x ? ……………………………………. Equation 2. In the equation 2, the intercept rf denotes risk free return, and the slope [{E(rM – rf) / ?M] denotes market price of risk. On the ? – E ( r) plane, a curve is drawn (See Figure 2), which is called minimum variance frontier (Fama &. French 2004). A tangent to this curve is drawn from the intercept rf.
