Question

Compare and contrast CAPM with multifactor models of stock returns with respect to assumptions, approach, estimation, benefits and limitations ect. Explain with examples and support your statements with evidence

Benefits (diversifiable risk) and limitations of multifactor models of asset returns (critique, refer to market shock studies)

Answer 1

Answer::-

I hopes it will helps you.

In finance the Capital Asset pricing model is a model used to determine a theoretical appropriate required rate of return of an asset, to make decisions about adding effects to a well diversified portfolio.

The model takes into account the assets sensitivity of non diversifiable risk often represented by the quantitative data in the financial industry as well as the expected return of the market .

The CPM is a model for pricing an individual security or portfolio for individual securities we make the use of security market line and its relation to expected return in systematic risk to show how the market price individual securities in relation to their security risk class.

Assumptions

To maximize economic utilities

Rational and risk averse

Broadly diversified across the range of Investments

Can lend and borrow unlimited amount under the risk free rate of interest trade without transaction or taxation

Information is available at the same time to all the investors

Advantages

Easy to use pricing model is a simplicity calculation that can easily stress tested to derive a range of possible outcomes to provide confidence around the required rate of Returns

Diversified portfolio the assumption that investors hold a diversified portfolio similar to the market portfolio eliminate and unsystematic risk

Systematic risk Capital Asset pricing model takes into account systematic risk which is left out of other return models such as dividend discount model systematic or market risk is an important variable because it is unforeseen and often cannot be completely mitigated.

Business and financial risk variability with business investigate opportunities if the business mix and financing differ from the current business The Other required return calculations like weighted average cost of capital cannot be used.

Disadvantages

Risk free rate the commonly accepted weight used as the end on short term government securities the issue with using this input is that the end changes daily creating volatility.

Return on the market the return on the market can be described as the sum of capital gains and dividend for the market a problem arises when at a given time the market return can be negative

Ability to borrow at risk free rate Capital Asset pricing model is based on four major assumptions including one that reflects and unrealistic real-world picture this assumption that investors can borrow and lend a risk free rate is unavailable in reality

Businesses that use this model to access an investment need to find beta reflective to the projector investment often a proxy beta is necessary however accurately determining to properly access the project is difficult and can affect the reliability of the outcome

Capital Asset pricing model says that the expected return of the security on a Portfolio equals the rate of risk free security plus service premium.

Weighted average cost of capital is used to calculate particular companies cost of capital combination of the cost of equity and the cost of debt a company's assets are financed by either equity or debt and the weighted average cost of capital is the average of the cost of these sources of Financing each of which is weighted by its respective used in the given situation

Weighted average cost of capital is the rate that a company is expected to pay on average to all it security holders to finance its assets

Capital Asset pricing model that describes a relationship between risk and expected return

Weighted average cost of capital is the weighted average rate of return a company expects to compensate investors the general idea behind Capital Asset pricing model is that investors needs to be compensated in two ways

Time value of money and risk

That the pricing model is the time value of money while later this is the cost of opportunity of money

Stands for which is a method to find out the correct price of stock or just about any asset future cash flow projection and discounted rate which is risk adjusted

Every company has its own projection of cash flows for next few years but investors need to figure out the real worth of these future cash flows in the terms of today's market in that case weighted average cost of capital is used