Economics of Corporate Finance
Capital Asset Pricing Model is the foundation stone of modern finance theory. It reveals the basic operation rules of the capital market and it is important in market practice and theory research(). By use of this model, the relation between risk and expected return is accurately predicted, and provides a method to estimate the yield of potential investment projects and help us to predict the expected rate of return of market in future. Although the Capital Asset Pricing Model is not entirely consistent with the empirical test, however, because of the simplicity of the model, it is still widely used. A model may have highly realistic assumptions, but if it has no predictive power, it is largely worthless. Most researchers have attempted to test the CAPM to see if it works, looking at the relationship between observed beta values and average returns(). One phenomenon is that the actual slope of the Security Market Line is slightly less than the predicted slope of the CAPM. This essay is going to discuss potential explanations of this phenomenon.
Most researchers test the CAPM by the basis of ‘risk premiums’, and the model is: E[R_i ]= r_f+β_i (E[R_Mkt ]- r_f), then it minus the risk-free return from both side and add an intercept term-α into this model, the intercept term should be zero, we can see new equation: E[R_i ]- r_f= α+β_i (E[R_Mkt ]- r_f). In this model, the beta is used to measure the systematic risk between investment and stock
In this literate review the most important papers about explaining stock returns from 1952, when Markowitz came up with Modern Portfolio Theory, till around 2011 will be discussed. As stated in Chapter 2, Jack Treynor was one of the first economists that started to work on the CAPM model. When he developed the CAPM in 1961, there was no way yet to fully test it. Because there were no samples large enough or of sufficient quality, the real testing of the CAPM started in 1970. In 1973, the world was shown the famous Black and Scholes options pricing model. One of the first studies that gave a different answer than the CAPM was the research by Basu (1977). While he agrees with the Efficient Market Hypothesis, Basu reaches another
Isolation Company has a debt–equity ratio of 0.80. Return on assets is 8.0 percent, and total equity is
CAPM is a model that describes the relationship between risk and expected return, and the formula itself measures the expected return of the portfolio. Mathematically, when beta is higher, meaning the portfolio has more systematic risk (in comparison to the market portfolio), the formula yields a higher expected return for the portfolio (since it is multiplied by the risk premium and is added to the risk free interest rate). This makes sense because the portfolio needs to
CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.
Assignment 1 is due after you complete Lessons 1 to 4. It is worth 20% of your final grade.
In the literature review, the author states that the CAPM has been the most favoured asset pricing model used since the 1960s. The CAPM though, has been questioned and its misspecifications identified since the 1970s, as the CAPM was unable to explain the risk measure and returns difference.
In order to test the validity of the CAPM, we have applied the two-step testing procedure for asset pricing model as proposed by Fama and Macbeth (1973) in their seminal paper.
HVN appropriate share price is $4.23 which is $0.12 higher than the actual closing price of $4.11. It is recommended for the investor to purchase more of the company’s share as it was undervalued. The sensitivity analysis shows the theoretical share price is very sensitive to change in WACC. Careful and continuous observation might be needed to constantly monitor the factors that can alter the WACC such as market return, the company’s beta, risk free rate, and tax rate. D/E ratio can also alter the WACC due to tax benefit on debt. This implies we should keep checking changes of the company’s capital structure, namely its financing decisions and activities because they are important factors to create value of the company.
Even though the CAPM still is relevant, several empirical tests have figured out a flatter SML than expected as well as a contrary return-beta relationship. Researchers have tried to explain this anomaly. One is the betting against beta factor mentioned by Frazzini and Pedersen and should be discussed in this essay.
There is great potential for large returns when investing in high-risk, aggressive shares, but there is no guarantee. As there are not many aggressive strategies that will work in every market, a maximum point could be selected that would lead to either the re-evaluation or liquidation of the investment when reached. Rubber Plc should also consider their investment time horizon– the longer the better when it comes to investing in aggressive shares. The preference for an extensive investment horizon is due to the fact that it will enable them to endure market fluctuations better. Since this type of investment is likely to be much more volatile, demanding more frequent alterations to adapt it to changing market condition, it requires a more active management rather than a conservative, buy-and-hold approach. The CAPM (Capital Asset Pricing Model) can be used by Rubber Plc to price the portfolio; it helps calculate risk and what type of return to be expected from the investment. The general idea behind the model is that investors should be compensated for their time value of money along with their risk. The model is described in this formula: expected return = risk free rate + Beta * (expected market return - risk free rate) If the aggressive shares have a beta of 1.5, for example, for every 10% increase in the market index return, the share return will increase by 15%. However, if the market return falls, then
The analysis of this paper will derive the validity of the Fama and French (FF) model and the efficiency of the Capital Asset Pricing Model (CAPM). The comparison of the Fama and French Model and CAPM (Sharpe, 1964 & Lintner, 1965) uses real time data of stock market to practise its efficacy. The implication of the function in realistic conditions would justify the utility of the CAPM theory. The theory suggests that the expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the expected return on the market portfolio, the variance of the return on the market portfolio, and
Eugene Fama from the University of Chicago and Kenneth R. French from the Yale School of Management's were done a research on examining the validity of capital asset pricing model (CAPM). It was published in 1992; and well-known as The Fama-French three factors model (TFM).
Capital market has deep developed this century, more and more investors go into this market. Which security is better? How to invest? Investors need numeric index to make decision. There are some theories to help investors: portfolio theory, capital asset pricing model (CAPM), option pricing model and so on. This essay will explain portfolio theory firstly. Secondly, this essay will explain CAPM and discuss the importance of the assumptions of CAPM. Thirdly, this essay will explain arbitrage pricing theory (APT) and factors model. Finally, this essay will compare CAPM with APT and factors model.
As the DIMEFIL paradigm defines economics and finance as two different fronts on which to battle terrorism, I will begin by defining the terms. The 'Economy ' of terrorism is to be considered on a local or interpersonal level; what are the ground level activities which finance terrorism, and who are the individuals who take part? The question must also be asked, what can be done to reintegrate these individuals into the country 's larger economic infrastructure?