The Capital Asset Pricing Model is a very useful model and it is used Essay

The Capital Asset Pricing Model is a very useful model and it is used widely in the industry even though it is based on very strong assumptions. Discuss in the light of recent developments in the area - Essay Example recent developments to see if it can be considered a credible and reliable model for asset pricing and forecasting for today’s dynamic business environment. The CAPM is seen as an asset pricing method which gives a theoretical determination of the required rate of return of an asset, given the condition that the asset is being added to an existing well-diversified portfolio (Berk, 1995). This means that estimating the rate of return of an asset based on the CAPM requires that the asset in question will not be an independent asset being invested but part of a portfolio considered to be well-diversified. Again, Fama & French (2002) stressed that the use of CAPM in asset pricing must be based on the use of assets which are considered non-sensitive to non-diversified risks which come as either systematic risk or market risk. In short, the asset must be a risk-free asset which guarantees the repayment of interest and principal with absolute certainty (Banz, 1981). There are several determinants and variables used in the calculation of CAPM and hence the CAPM formula. There are generally traditional and modified formulas for CAPM but this pap er is limited to the use of the traditional formula. Fama & French (1992) stressed that for CAPM usage, it is important that the expected return on the capital asset E(Ri), which can only be known when the risk-free rate of interest Rf, sensitivity of the expected excess asset or beta ßi, expected return of the market E(Rm), and market premium E(Rm) – Rf are all known. With these known, it is possible to obtain the CAPM given as For the actual applicability of the equation and SML to function, there are very important assumptions that must hold. In all, CAPM makes use of nine assumptions which are briefly analysed as follows. The first is that investors aim to maximise economic utilities. Based on this assumption, investors would only want to go into investments that have asset quantities that are known and fixed so that the