Table of Contents
1. Introduction 3
2. CAPM 3
3. Global CAPM 4
4. International CAPM 4
5. Conclusion 5
6. Reference 5
According to the survey conducted among the most successful US enterprises, 73-85% of the respondent claims to use CAPM as their preferred methodology (Desai, 2005), thereby making CAPM most widely used model to estimate cost of equity. CAPM model is used to estimate the expected return on a risky asset by adding to the risk free rate of return a market risk premium. Sharpe and Lintner built CAPM theory on basis of Markowitz theory of mean- variance portfolio model.
1. Assumption of CAPM
Markowitz mean- variance analysis refers to the theory of combining risky assets so as to minimize overall risk of the portfolio at desired level of return. The Markowitz theory is based on three assumption i.e. all investors minimize risk for desired level of expected return or demand additional return for additional risk (risk averse), all parameter of individual asset like expected returns, variance and covariance are known thereby all investors have same expectations of all asset parameter and there are no taxes or transaction cost. Sharpe and Lintner add two key assumptions to the Markowitz model to derive CAPM - individual buy and sell decision does not affect asset price (price takers) and investors can borrow and lend unlimitedly at risk free rate.
2. Limitation of CAPM Assumption
The assumption that the investor consider only expected return, variance and covariance of asset in the portfolio is not practical, as the investors also consider the relation of their portfolio return with labour income and future investment opportunities that would be offered by the market.
CAPM assumes that all investor have same portfolio, thereby implying that all investor have same time horizon for holding a portfolio, which is not the...