Capital asset pricing model (CAPM) Essay Example | Topics and Well Written Essays - 1750 words

Capital asset pricing model (CAPM) - Essay Example In the following years, economists have critically reviewed the published theory of CAPM and its application in reality after comparing the actual returns with the expected returns. The CAPM model is still widely used by companies as an efficient model for computing cost of capital (Ko) on the basis of explanation that securities with higher betas offer higher return. CAPM has numerous applications; it is used in capital budgeting, for analysis of merger and acquisitions, valuation of convertible securities and warrant and to value the equity of a firm. William Sharpe made several assumptions for investors in creating market equilibrium in order to validate the CAPM model (Sharpe, 1964). The model develops the price of an asset which it must hold in order to satisfy the investors for holding the current market portfolio. According to CAPM, everybody bears the same risk in different quantity. As the systematic risks is removed and the investors hold diversified portfolios, they will have a need for return and according to the utility function, the investor will rank the portfolio. All the investors will tend to buy the market portfolio as everybody possesses the same portfolio comprising of risk bearing assets. Furthermore, by purchasing several other assets, it is possible for the investor to diversify a part of the risk. The riskiness of a security is not entirely based on the unpredictability of its return. If one investor puts all his money in a single asset, then variability would be a suitable measure.