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Case Study Analysis #1 How successful has been the CAPM in explaining return on risky assets? What are the known issues? Is beta stable? (APT Style )

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Case Study Analysis #1

How successful has been the CAPM in explaining return on risky assets? What are the known issues? Is beta stable?

(APT Style )
Answered Same Day Jul 15, 2021

Solution

Neenisha answered on Jul 17 2021
137 Votes
Capital Asset Pricing Model (CAPM) and its success on risky assets
Introduction
CAPM is used to understand the expected returns on assets accounting for systematic risk.
According to CAPM,
Where,
There are two factors involved – time value of money and risk free rate.
Any investor would be willing to take risk only if he gets enough return which is above the risk free rate prevailing in the market. Therefore, risk free rate in the model accounts for the factor above which any investor would be willing to get as he is risking his money. Otherwise he would have gotten at least risk free rate if he would have put that money in bank. Now beta accounts for the systematic risk which is prevailing in the market and which investor is taking. Beta is then multiplied to Market Risk Premium which is the market return above the risk free rate. Therefore, in this manner we get expected return on the asset accounted for the systematic risk in the market.
Capital Asset Pricing Model (CAPM) explaining return on risky assets
The model incorporates the returns and risks on financial securities. When investors invests money in stocks then they might earn or lose money because of volatility of stock market. Therefore, companies trading their shares on the securities market are considered to be risky assets while the bonds or the treasury bonds whose value do not change and are not subjected to fluctuations since they are backed by government are considered to be riskless investments. The idea is to earn more than the return on risk free assets. According to the financial theories, risk can be defined as when the actual returns deviated from the returns which are expected.
However, CAPM is able to take care of these risky assets by way of diversification. According to this, if we combine one risky asset with the other less risky asset then the risk is neutralized to some extent. This means that combining one asset with the other which has negative or lower degree of co
elation.
Example: If we have only two companies – X and Y. Company X manufactures sun lotions, therefore, it performs good in sunny weather but if it is rainy season then the company would not perform good. The average return on the company is 12%. On the other hand, if we have company Y, which manufactures um
ellas. The company does good in rainy season but does not perform well in sunny season. The average return on the company Y is also 12%. Both the companies have average return of 12%, but they are very risky and subjected to fluctuations because their business is seasonal. However, the co
elation between the two companies is negative because if one company will perform good then the other company will not perform good. Hence we invest in both the companies and our portfolio has an average return of 12% without any risk unlike the previous case where we had an average return of 12% but this return was subjected to fluctuations.
However, one thing to be looked here is that this kind of perfectly negative relation is not possible to have in real life scenarios. Therefore, we try to have the...
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