CAPM Essay Example | Topics and Well Written Essays - 1500 words

CAPM - Essay Example The CAPM presents partial equilibrium model where agents consider the risk free returns and the probability distributions of the future returns on risky assets as being exogenous. In this paper, I seek to give an in-depth understanding of this model by delving into the logic behind it, exploring critiques levelled against it, and explaining why it is still the model of choice in financial analysis. Finally, I give practical examples of its practical application that show evidence of its usefulness and continued use to date. The CAPM is built on the portfolio model that Harry Markowitz (1959) developed. In the model, a portfolio is selected by an investor at time t-1 which at t produces a stochastic return. Investors are assumed to be risk averse and, in their choosing among portfolios, care is only taken on the mean and the variance of their single-period investment return. This results in investors choosing â€Å"mean-variance-efficient† portfolios, the portfolios in this case 1) given variance, maximizes returns and 2) given expected returns, minimize portfolio return variance. For this, the approach is referred to as mean-variance model. An algebraic condition is provided by the model on asset weights in portfolios that are mean-variant-efficient. This algebraic statement is turned by the CAPM into a prediction that is testable about the connection between expected returns and risk through identification of an efficient portfolio if asset prices should clear all the assets off the market. To identify a mean-variant-efficient portfolio, Sharpe and Lintner added two crucial assumptions. The first one is complete agreement: taking asset prices to clear the market at t-1, it is agreed by investors that asset joint distribution returns from t-1 to t. This distribution is taken to be the true distribution, i.e. it provides the distribution giving returns that we employ in testing the model. Secondly, there is risk-free rate