Outline and discuss the Capital Asset Pricing Model (CAPM) as means of Essay

Outline and discuss the Capital Asset Pricing pose (CAPM) as means of valuing securities and their bump. What are the drawbacks - Essay archetypeThus each firm has to bear the cost of debt and cost of equity. These costs are calculated through various financial models designed to give an accurate analysis of the costs the firms have to bear. There are three models used by analysts and firms to calculate their cost of capital the Capital Asset Pricing Model (CAPM), the Dividend Valuation Model and the Arbitrage Pricing Theory. The focus of this report is the CAPM model and a comparison between this model and the Dividend Valuation Model. The capital asset determine model attributable to Sharpe (1964) is a cornerstone of modern financial theory and originates from the analysis of the cost of capital. (Chouodary 2004) this market model encompasses the concept of risk and comes under the soil of risk premium market models. This model takes into account the risks borne by the inves tor for investing in the securities. When an investor puts his money in any security he faces many risks ranging from liquidness to inflation etc. The underlying principle of the capital asset pricing model is that investors want to be compensated for bearing the risk in the plant of extra return. This extra return is over and above the risk free rate as risk free securities have no risk repayable to their guaranteed nature. All government securities are risk free as the government will pay back all its investors and there is no default voluminous in this case. Thus, before actually giving you the CAPM equation one needs to understand the logic of risk and return i.e. the concepts that make up the component of the CAPM equation. assay and return valuations are the most important part of investment funds decisions. The risk and return go proportionately with each other i.e. great the risk greater will be the return. Deriving from the basics an expected return is the mean of the probability distribution of possible future returns. The expected return on an investment is the average return from the investment and is calculated as the probability weighted sum of all potential returns.(Rao, 1989) The concept of risk and return arises due to the unbelief of future outcomes. The underlying factor here is that the actual return received may be different from the expected return, thus generating risk for the investors. All financial assets produce cash flows and the riskiness of these assets is derived from the riskiness of these cash flows. An asset considered in isolation carries stand-alone risk and is considered to be less risky as compared to when it is held in a portfolio. In a portfolio, assets with different expected return are grouped together. The risk of the portfolio is divided into two parts diversifiable risk and market risk. The diversifiable risk is the one that can be eliminated and therefore this type of risk is not accounted for in the risk co mputation. The risk that the investors are really interested in collusive is the market risk (the non-diversifiable risk) i.e. the relevant risk which arises from the broad market movements. The measures of the risk are variance and standard deviation. The variance of a stock can be calculated using the below formula provided the required rate of return is given N Var(R) = ?2 = ? pi(Ri ER)2 i=1 Where N = the number of states pi = the probability of state i Ri = the return on the stock in state i ER = the expected return on the stock The positive square root of variance is standards deviation which