The CAPM is a valid pricing model and can be trusted to explain the Essay

The CAPM is a valid pricing model and can be trusted to explain the expected return on a security. Discuss - Essay Example The followed discussion will be on in-depth explanation of the ÃŽ ² factor in the equation of the model. The purpose of the paper will hopefully be fulfilled by discussion on these related issues to the model. CAPM was developed during the mid 1960s with several assumptions about the market and the behaviour of investors, giving certain equilibrium conditions which allow an investor to calculate the return of an asset for a given level of systematic risk. CAPM makes use of a measurement of systematic risk which can be used to make a comparison of other assets in the market. In order to arrive at the equilibrium condition of CAPM, certain assumptions have to be defined: CAPM is a model by which the relationship between the risk and expected return on an asset can be determined and this is widely used in pricing of risky securities. The equilibrium condition of the CAPM is as follows: The concept of CAPM starts with a risk-free rate (may be yield on a 10 year government bond). With this concept, a premium is added which is equity investor’s demand for compensation on holding an extra risk. This premium is also known as the equity market premium which is calculated as expected return from the market less the return on risk-free asset. This premium is then multiplied by a coefficient called ‘beta’ (McClure, 2010). In the above figure, the efficient frontier is the line which consists of optimal portfolios and is created from the risk-return graph. The Capital Market Line (CML) is a tangent drawn from the intercept point on efficient frontier to the point where the risk-free rate of return is equal to the expected return. The CML is better than the efficient frontier because it considers risk-free asset in the portfolio (Investopedia, 2010). The SML is a line that shows the systematic risk and whole market return at a certain point of time and this line shows the entire risky assets. The SML is very useful in evaluating the expected return on an asset