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Write an essay regarding the utility of the CAPM. Define the CAPM equation, then discuss strengths, weaknesses, and an assessment of its effectiveness.
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Over 1,300 words (4 pages). APA format with references. Includes specific references to aid in defining CAPM variables and specific formula for accomplishing a CAPM valuation.
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The Capital Asset Pricing Model (CAPM) provides some scienceââ?¬"albeit using some over simplified variablesââ?¬"to determining the cost of equity for a business. The core of CAPM stems from comparing the risk of a security against the risk-free rate of return to determine a risk-adjusted required rate of return on the security in question. The formula is as follows:
R_A= R_F+ Ã?²_A (R_M-R_F )
Where: RA equals the required rate of return on a specific asset
RF equals the risk-free rate of return
Ã?²A equals the Beta of the asset in question
RM equals the expected return on the aggregate market
The strength of the CAPM is in its simplicity and ease of calculation. However, significant shortcomings quickly become apparent upon further consideration of each variable.
CAPM VARIABLES AND ASSUMPTIONSââ?¬"RISK FREE RATE
Expanding the above calculation from left to right, each variable introduces new assumptions, and becomes progressively more contentious. RF comprises the risk-free rate. While traditionally, RF would use a ââ?¬Å"zero coupon government bond matching the time horizon of the cash flow being analyzed,ââ?¬Â? the time horizon for asset return consideration is typically flexible, (Damodaran, nd). This presents several options for the investment analyst. If a specific time horizon is knownââ?¬"then the risk-free rate of that specific time period should be used. There are several options for where to start, but identifying the type of government bond provides a critical first step.
The United States Treasury Department offers a variety of fixed rate investment assetsââ?¬"ranging from the short-term T-bill to the long-term T-bond. T-bills most closely match the traditional definition of risk-free rate, as they are zero-coupon assets that mature in less than a year, (TreasuryDirect, 2011a). The current rate of return (as measured by yield) for a 12 month T-bill is 0.11%, (Bloomberg, 2011).
For a longer-term investment, however, a different risk-free asset should be used. T-notes and T-bonds are US government securities with maturities of 1-10 and 20-30 ...
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