2486 words - 10 pages

Comparing and Contrasting Pricing Model

In this paper I will discuss the growth and development of the Capital Asset pricing Model (CAPM).I will also identify and analyze the different applications to the CAPM. I will try and illustrate how the model can be used to form expected return and valuation measures. These illustrations will be informed by examples from stock options and restricted stock. Finally I will conduct a comparative analysis of the potential outcomes associated and comparative benefits and risks for using the CAPM versus the Arbitrage pricing theory (APT).

Evaluating the development of the Capital Asset pricing Model (CAPM)

How should the risk of an investment, affect its expected return (Perold, 2004)? According to Perold (2004) the Capital Asset Pricing Model (CAPM) was the first coherent framework developed by Sharpe, Lintner and Mossin in 1964, 1965 and 1966 respectively, to answer this question. CAPM fundamental premise is that not every risk should affect an asset’s price, specifically risks that can be diversified away when held alongside other investments in a portfolio, cease to be risks at all (Perold, 2004).

The original CAPM was engineered in a imaginary space, where the following assumptions about investors and the opportunity set were made (Shih, Chen, Lee & Chen, 2014).First, risk-averse investors will maximize the expected return of their wealth(Shih et al,2014).Secondly, price-taking investors have homogenous expectations about joint normally distributed asset returns (Shih et al., 2014).Third, there exists an unlimited amounts of risk-free assets that investors can lend and borrow at a risk-free rate (Shih et al., 2014).Fourth, there are a fixed amount of evenly divisible and marketable assets(Shih et al., 2014).Fifth, information is freely and simultaneously available to all investors in a frictionless asset market(Shih et al., 2014).Sixth, market imperfections like taxes, regulations and restrictions on short-selling do not exist(Shih et al., 2014).

The CAPM has been used as a benchmark of asset pricing, in the past four decades and it has been applied in the calculation of asset returns and cost of capital by most empirical studies (Shih et al., 2014). Dybvig and Ross (as cited by Shih et al., 2014) say that CAPM trumps other modern pricing models because it provides most of the basic intuitions for the risk-return tradeoff, pricing of market risk, and the inability to price idiosyncratic risk(Shih et al.,2014).

Due to restrictions of the six assumptions previously mentioned, attempts have been made to create more general asset pricing models by tweaking the CAPM assumptions and testing the empirical implications (Shih et al., 2014).The authors organized their survey on CAPM into a static CAPM and dynamic CAPM research flows (Shih et al., 2014).The static CAPM research flow examines attempts that have been made to tweak one of the assumptions of CAPM (e.g. differential taxation of dividends over capital...

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