Capital Assets Pricing Model Harvard Case Solution & Analysis

Abstract

The core purpose of the research paper is to conduct the study of CAPM (Capital assets pricing model). The capital assets pricing model suggests that the cost of investors can be estimated and determined by the risk-free rate, market risk premium and can be also determined by Beta. The measure of the risk of systematic risk is mainly based on the systematic risk and the return move with the overall market.

Some of the empirical evidences suggest that the downside beta captures the market relationship between the risk, and the return involved in the developing and the emerging market. The research report also showed that the average downsize beta can be 360 degree different than the traditional beta.

In the research report, the core implications in the usage of downsize beta on valuation are discussed in detail; it is discussed and illustratesthe application for both diversifies and undiversified risk of the investors.

Introduction

In the field of finance, corporationsraise funds from Debt and Equity. Debt raisingis the process through which the company owns money from the investors in return of interest payment and that interest payment is the return for the creditor and cost for the cooperation. (Bodie, 2008)

Moreover, the corporationsraise equity from the investors and thoseinvestors invest in the company as the owner of the company, and their investment is known as equity finance.Also, againstthat equity financing against some percentage from the cooperation’s profitability.

 In order to find out the return on investment for investors and cost of capital for the partnership, it is necessary to conduct an estimation of the cost of equity, and it can be found through different methods. The capital assets pricing model is one of the models used for calculating the cost of equity for the cooperation.

In the field of finance, risk measurement and the future cost arethe important and critical paths of the subject. The capital assets pricing theory is the pricing model that is used to estimatethe value of financial assets and instruments such as shares, future, options, and bond.

 One of the researchers, Markowitz (1964) researched on the portfolio management in order to find the risk of the financial instruments. He created the theory of portfolio and conducted critical research on the method of diversification and critically analyzed the relationship between the risk of the financial security and return get on those financial securities.

In order to get the result using portfolio theory, we should consider some assumptions in order to find the results by using the portfolio theory.

The assumption for the portfolio theory is that all investors use the utility function with the average yield on the financial securities and risk associated with that is used as an independent variable to take the decision,inorder to find out the risk associated with the financial assets and the return on financial assets.

Risk and benefits are directly proportional to each other and while analyzing the relationship between Risk and Return,theresearcher researched and put forward Capital Assets Pricing Model and abbreviated as CAPM. The CAPM model is the model that is used to identify pricing for an individual security or portfolio. For individual securities, we make use of the security market line (SML).

SML equation is the graphical representation of CAPM and formed by the relationship between expected return and systematic risk (Beta).It is used to show the position of the market and how the market must price individual securities in relation to their security risk class. The Security Market line is widely used to calculate the risk to reward ratio for any financial securities in relation to the overall market. (Daniel, 2001)

There are two types of risk which arefaced by the investors such as unsystematic risk (diversifiable) and systematic risk (non-diversifiable). Unsystematic risk can be minimizedby diversification of investment securities and it is the risk associated with the portfolio management, and it can be reduced or eliminated by constructinga well-diversified portfolio.Capital Assets Pricing Model Case Solution

Systematic risk can be a major risk and it is associated with the overall movement in the general market or overall economy and therefore, it is referred to be the market risk. The market risk is one of the components of Capital Assets Pricing Model, and it cannot be eliminated through portfolio diversification........................................

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