Finance Assignment CAPM

CAMP can be used when pricing the risk of securities. It Is the expected return of a security or a portfolio which equals the rate on a risk-free security along with a risk premium. The CAMP was introduced independently by Jack Trenton (1961, William Sharpe (1964), John Lintier (AAA,b) and Jan Mission (1 966), who were building on the earlier work of Harry Margarita on diversification and modern portfolio theory. (Ref;. Formula As already stated above, CAMP is a model for pricing an individual security or portfolio.

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When looking at individual securities, we make use of the security market line (SMS) and its relation to expected return and systematic risk (beta) to show how the market must price Individual securities In relation to their security risk class. (Ref: 2,5,6). The SMS enables us to calculate the reward-to-risk ratio for any security In relation to that of the overall market. Therefore, when the expected rate of return for any security is deflated by its beta coefficient, the reward-to-risk ratio for any individual security in the market is equal to the market reward-to-risk ratio, thus:

The market reward-to-risk ratio is effectively the market risk premium and by rearranging the above equation and solving for E(RI), we obtain the capital asset pricing model (CAMP). CAMP is modified to include specific risk and also size premium. For investors in private held companies this is extremely important as they don’t tend to have well- diversified portfolio. The equation is similar to the traditional CAMP equation “with premium: Portfolio Theory Portfolio theory assumes that investors are all risk adverse, meaning they avoid risk. However research has shown that this is not the case.

Investors will take on risk if the returns that are on offer are sufficient. The attraction of an investment is divided up by the risk and expected returns, this is measured by standard deviation. Its results, taken at face value, are not accurate if we consider diversification over long horizons, asymmetric information/differences in opinion, transactions costs, noontide ability of certain assets, and other imperfections. In financial markets. Regardless, portfolio theory remains an important component of finance theory for three reasons: CAMP,

Diversification and its represents the first major breakthrough in the theory of Finance. (Ref: 3,4,5). CAMP assumes that all active and potential shareholders will consider all of their assets and optimize one portfolio. This is in sharp contradiction with portfolios that are held by individual shareholders: humans tend to have fragmented portfolios or, rather, multiple portfolios: for each goal one portfolio. (Ref: 3,4,5). Assumptions and problems of CAMP CAMP has many assumptions about investors.

This model attempts to quantify the relationship between the beta of an asset and its corresponding expected return. A lot of assumptions are made under this model but the most important ones to disclose are about investor’s behavior and the presence of a single common risk. (Ref: The first assumption made is that investors are only concerned with expected returns and volatility. So as rational consumers, they should always maximize expected return for any given level of volatility. This follows on to the second assumption- all investors have homogeneous beliefs about the risk/ reward tradeoffs in the market. Ref: Another assumption that CAMP makes is that all investors are broadly diversified cross a range of investors, that they cannot influence price- this is certainly not the case for most economics markets nowadays. The model assumes that given a certain expected return, active and potential shareholders will prefer lower risk (lower variance) to higher risk and conversely given a certain level of risk will prefer higher returns to lower ones. (Ref: 3,4,5). In conclusion While CAMP still leads the pack as one of the most widely studied and criticized from the start as being too unrealistic for investors in the real world.