The Capital Asset Pricing Model (CAPM) Essay Example | Topics and Well Written Essays - 1250 words

The Capital Asset Pricing Model (CAPM) - Essay Example However lending has an interest rate attached to it. In the open market, it is also assumed that traders have all relevant information rates of stocks and other co-variances. Traders in an open market are also assumed to be rationale about being risk averse and all investors have same assets to choose from given all information concerning the assets and same decision methods are applied (Burton, 1998). This brings us to the concept of the capital asset pricing model (CAPM). The model is very useful and is widely used in the industry, although it is based on very strong assumptions. This paper will focus on brief theory of arbitrage theory of the CAPM model, main theories behind this model and their critique. First, the model is quite useful as it focuses on determining the required rate of return appropriate for a company’s assets. The model requires various firms to have a portfolio that is well diversified, as long as the risks prone to the assets cannot be diversified (Brealey, et al 2009). Practically, most companies utilize CAPM model to determine the price of a security or a portfolio. In this case, a security market line that defines the relationship existing between the beta and expected rate of return of an asset is utilized. The line also enables firms to calculate a ratio that equates an asset’s rewards to its risks. It is also through the model that firms are able to determine the rate at which an asset’s cash inflows expected to be generated in future should be discounted. This takes into account the cash inflows in relation to the risks existing in the market. The arbitrage model was an alternative to the means variance capital asset pricing. Currently, the model has become a crucial tool in explaining the phenomenon mostly observed in the capital markets that deal with risky assets. One assumption of the capital asset pricing model is the assumption of normality in returns. It is from this assumption that the linear elation stipulated above originates. The assumption has had critique since theoretically, there does not exist guarantee to such efficiency. However, there is restrictiveness that underlie the mean variance model; therefore being the evidence of the existence of the linear relationship between risks and returns. This led to the popularity of the model. It was until later that Ross introduced a new model that would yield better results when pricing risky assets. The arbitrage model would hold both in equilibrium and all sorts of disequilibria unlike the mean variance analysis. However, there are some weaknesses in relation to this theory. For instance, when dealing with the number of assets, as assets increase, their r eturns are also expected to increase. This will result to an increase in risk aversion to investors. The arbitrage model has the law of large numbers where the noise term becomes negligible as the number of assets expands. Where the degree of risk aversion increases with the increase in the number of assets, the two effects cancels out, leaving the noise term to have a persistent effect on the pricing decision. In developing the arbitrage theory, several assumptions were put into consideration. First is the assumption of limitations on liability. It is assumed that there exists at least one asset which has a limited liability. This means that there are some bound per unit to the losses for which an investor is liable. The second assumption was based on the homogeneity of expectations. All the investors hold the same expectations, since all have the same assets, information and are risk averse. There also exists at least o