Capital Asset Pricing Model Case Study

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3.2.3.2 The Portfolio Theory and the Capital Asset Pricing Theory (CAPM) One of the most celebrated theories in financial economics is the Capital Asset Pricing Model (CAPM), a single-index asset pricing equilibrium model developed separately by Sharpe (1964), Lintner (1965) and Mossin (1966). CAPM has been very influential as it is widely used as a benchmark to measure the value of financial assets and capital budgeting projects as well as to assess fund managers‟ performance. Prior to CAPM, financial assets were mainly evaluated on the basis of their individual return whilst performance of investment funds were assessed mainly through relative measures such as fund ranking techniques due to the unavailability of a specific market equilibrium…show more content…
It depicts a linear relationship theory between return and risk (or mean-variance relationship) based on the underlying assumptions: (1) All investors are risk-averse and would choose an efficient portfolio that would maximise their end-of-period expected utility (the marginal utility decreases as wealth increases); (2) All investors have the same one-period investment horizon; (3) All investors measured portfolio performance solely based on mean and variance (return and risk) and they all have homogenous expectations on the distribution of the end-of-period future returns; (4) There is no friction in the trading of financial assets such as the absence of taxes or transaction costs, and that the financial market is informationally efficient; and, (5) All investors can choose to invest in any financial assets, and they may borrow or lend any amount of money at the rate similar to risk-free rates. Under these assumptions, the CAPM shows that the expected return for an asset or portfolio i is related to the expected excess return of the market portfolio adjusted for the systematic risk of the asset or portfolio, commonly represented…show more content…
Both methods are discussed in the following sections. Portfolio Performance Measurements Based on the Mean-Variance Criterion Prior to the CAPM, analysis of the mutual fund performance was based primarily on performance ranking techniques due to the unavailability of a benchmark against which the mutual fund performance can be compared. Through the CAPM, researchers were able to formulate an absolute measurement value to evaluate mutual fund performance. The three most widely used risk-adjusted portfolio performance measures are the Treynor index (Treynor, 1965), the Sharpe index (Sharpe, 1966), and the Jensen-alpha index (Jensen, 1968). The three measures were principally derived from the CAPM equation. Friend and Blume (1970) provide a concise description of the derivation process. Assuming that all the CAPM assumptions hold, the financial market is said to be in equilibrium with the individual asset or portfolio (represented by the symbol i) poised

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