Evaluation of CAPM using American stock market data Dissertation

Evaluation of CAPM using American stock market data - Dissertation Example So investors prefer to choose mean-variance-efficient portfolios that would either minimize variance with a given expected return or would maximize expected return given variance. Thus, CAPM is a theory that defines the relationship between risk and the expected return of a security or a portfolio of securities. The theory is based on the assumption that the security market is generally composed of risk-averse investors and the type of investors who prefer and will to take more risk only when they expect to earn a higher return in commensuration with that risk. The return from an asset varies through successive periods and an asset which has a fluctuating return is considered to have greater risk. So, the tendency of investors is to diversify their investment portfolio so that they could minimize the effect of risk volatility, i.e. the unsystematic risk attached to the portfolio. Thus due to diversification only market related or systematic risk is relevant in the risk-return trade-o ff. The portion of risk volatility which is systematic, i.e. measured by the extent to which return varies with respect to the overall market, is measured by the parameter ? (Beta). Beta is a measure of risk contributed by individual securities to a well-diversified portfolio, and measured by- rA = return of the asset rM = Return of the market ?2M = variance of the return of the market cov(rA, rM) = covariance between the return of the asset and the return of the market. Beta is calculated with the help of historical returns for both the asset and the market. Assumptions of CAPM The assumptions of CAPM are- Investors in the market are concerned only about the expected return and the volatility of risk involved with their investment All investors have homogeneous idea about the concept of risk and return associated with an investment. Systematic risk factor is common to a broad-based market portfolio as systematic risk brings volatility which is non-diversifiable. So, if a securities beta can be identified, then the expected return from that security can be calculated. Economic Rationale behind CAPM and its Consistency with the regulatory and the economic standards The relationship in risk and return in CAPM is measured using- Where, Rt = the expected return on a security or a portfolio Rf = Risk-free rate of return ?i = Beta of the security or portfolio i Rm = expected return on the equity market performance The rationale behind the CAPM equation is to persuade the investors to shift their money from riskless assets to risky assets such as equity security. The usefulness of CAPM lies in the measurement of the expected return premium appropriate for an investment with respect to the risk involved relative to the market index risk. The economic explanation of the equation brings out that how risk-free rate of return (Rf) and market-wide risk premium (Rm- Rf) aid to persuade investors from investment in risk-free securities to risky securities.