CAPM

CAPM is an abbreviation for capital asset pricing mode. In this model the relationship between the risk involved and the return expected is found, using this relationship the price for the asset is determined. The model was found by  Jack Treynor, Willian sharpe, John Lintner and Mossin each in their independent research, which was based on the earlier  work of Harry Markowitz on diversification and modern portfolio theory.

The formula used in this model is

Ks = Krf + β( Km – Krf)

Where risk free rate is denoted as ks, beta of the security is termed as β, and expected rate of return as km.

This model is basically used by the investor when he/she has a diversified portfolio. In this model the investor will go ahead with investment if the return is greater than or equal to the sum of the  value of riskless asset and the premium associated with the risk.

Some of those assumptions that were made while developing this model are,

• Every possible investor of the asset has the same information at the same time.
• The model can be used only for a particular period.
• Asset return is distributed normally as in probability distribution.
• The existence of risk free asset.
• There are a countable number of assets.
• The market considered is an ideal one.
• The lending rate and the borrowing rate are equal through out the period.
• The market restrictions like tax, regulation by the authority are not considered while developing this model.

Even though some of the above assumptions are invalid or not possible in the real market this model are widely used by the investor in analyzing the relationship between risk and return of an asset. The main advantage in using this method is that it is useful in comparing the systematic risk of one of the asset with another asset.

CAPM is therefore used by the investor in developing a portfolio whose risk and return are known. It should be noted that the return might not be the same in real life situation as that calculated in this model but the return might be to a greater extend will be in the proportional way as found in the model.