Outline and discuss the Capital Asset Pricing Model (CAPM) as means of Essay

Outline and discuss the Capital Asset Pricing Model (CAPM) as means of valuing securities and their risk. What are the drawbacks - Essay Example Thus each firm has to bear the cost of debt and cost of equity. These costs are calculated through various financial models designed to give an accurate analysis of the costs the firms have to bear. There are three models used by analysts and firms to calculate their cost of capital; the Capital Asset Pricing Model (CAPM), the Dividend Valuation Model and the Arbitrage Pricing Theory. The focus of this report is the CAPM model and a comparison between this model and the Dividend Valuation Model. â€Å"The capital asset pricing model attributable to Sharpe (1964) is a cornerstone of modern financial theory and originates from the analysis of the cost of capital.† (Chouodary 2004) this market model encompasses the concept of risk and comes under the domain of risk premium market models. This model takes into account the risks borne by the investor for investing in the securities. When an investor puts his money in any security he faces many risks ranging from liquidity to inflat ion etc. The underlying principle of the capital asset pricing model is that investors want to be compensated for bearing the risk in the form of extra return. This extra return is over and above the risk free rate as risk free securities have no risk due to their guaranteed nature. All government securities are risk free as the government will pay back all its investors and there is no default involved in this case. Thus, before actually giving you the CAPM equation one needs to understand the logic of risk and return i.e. the concepts that make up the component of the CAPM equation. Risk and return valuations are the most important part of investment decisions. The risk and return go proportionately with each other i.e. greater the risk greater will be the return. Deriving from the basics an expected return is the mean of the probability distribution of possible future returns. ‘The expected return on an investment is the average return from the investment and is calculated as the probability weighted sum of all potential returns.’(Rao, 1989) The concept of risk and return arises due to the uncertainty of future outcomes. The underlying factor here is that the actual return received may be different from the expected return, thus generating risk for the investors. All financial assets produce cash flows and the riskiness of these assets is derived from the riskiness of these cash flows. An asset considered in isolation carries stand-alone risk and is considered to be less risky as compared to when it is held in a portfolio. In a portfolio, assets with different expected return are grouped together. The risk of the portfolio is divided into two parts: diversifiable risk and market risk. The diversifiable risk is the one that can be eliminated and therefore this type of risk is not accounted for in the risk computation. The risk that the investors are really interested in calculating is the market risk (the non-diversifiable risk) i.e. the relevan t risk which arises from the broad market movements. The measures of the risk are variance and standard deviation. The variance of a stock can be calculated using the below formula provided the required rate of return is given: N Var(R) = ?2 = ? pi(Ri – E[R])2 i=1 Where: N = the number of states pi = the probability of state i Ri = the return on the stock in state i E[R] = the expected return on the stock The positive square root of variance is standards deviation which