Question

1.What is Capital Asset Pricing Model (CAPM)? What is it used for ?

a) There have been discussions about how useful the Capital Asset Pricing Model (CAPM), does it actually work or is "beta dead"?

b) Why is the model important in Finance ?

Answer 1

A: The capital asset pricing model is a useful model in finance which highlights the relationship between systematic risk and required returns. This model is primarily used to calculate the required returns of stocks in particular. As per the CAPM,

Required rate of return= risk-free return+ Beta* market risk premium. The model states that, stocks which have a higher risk would require to give a greater rate of return to the investors and vice versa. The model is still valid because, beta is a good measure of systematic risk and the relation between risk and return still exists.

B: in finance the capital asset pricing model is used for computing the required return of stocks. Businesses need to calculate the weighted average cost of capital for various purposes in finance such as capital budgeting. A prime component of WACC is the cost of equity which is the required rate of return computed using CAPM model.