The Capital Asset Pricing Model

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The Capital Asset Pricing Model A widely accepted …nancial model for estimating the cost of equity capital is the Capital Asset Pricing Model (CAPM). In this model, the cost of equity capital (or the expected return) is determined by the systematic risk a¤ecting the …rm. The mathematical formula underlying the model is r = rf + (rm ¡ rf )¯; where r is the expected return on the …rm’s equity, rf is the risk-free rate, rm is the expected return on the overall market portfolio, and ¯ is the equity beta that measures the sensitivity of the …rm’s equity return to the market return. Using the CAPM requires us to choose the appropriate measure of rf and the expected market risk premium (rm ¡ rf ) and to calculate the equity beta. The market risk premium can be obtained from a time-series model for market returns. The simplest estimation is the average of historical risk premiums, which is available from various …nancial services such as Ibbotson Associates. The equity beta is calculated as the slope coe¢cient in the regression of the equity return on the market return. The equity beta can also be obtained from …nancial services such as ValueLine or Merrill Lynch. The classic empirical study of the CAPM was conducted by Black, Jensen and Scholes (1972) and updated by Black (1993). They show that the model has certain shortcomings: 7 the estimated security market line is too ‡at; the estimated intercept is higher than the riskfree rate; and the risk premium on beta is lower than the market risk premium. To correct this, Black (1972) extended the CAPM to a model that does not rely on the existence of a risk-free rate, and this model seems to …t the data very well for certain portfolios. Fama and French (FF, 1992) argue more broadly that there is no relation between the average return and beta for U.S. stocks traded on the major exchanges. They …nd that

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