CAPITAL-ASSET PRICING MODEL - PROBLEM, SOLUTION, EXAMPLE

The concepts discussed in this paper provide the theoretical background of the Capital Asset Pricing Model (CAPM). The CAPM rests on a set of unrealistic assumptions. However, simplifications of reality are often necessary to develop useful models. The true test of the model hes in the power and validity of the model's prescription. According to the CAPM, expected rates of return on financial securities are refected by their riskiness. The model uses a coefficient ''beta'' to compare the riskiness of a security with the riskiness of the market as a whole. Thus, beta is a shorthand for relative volatility. Furthermore, the relevant measure of the security's riskiness is its market-related risk. This is called systematic or nondiversifiable risk. On the other hand, the unsystematic risk component is diversified away and is therefore irrelevant for the determination of the security's expected return. A security with a beta of one is just as risky as the market; one with a beta of 0,5 is less risky. Because investors need to earn more on riskier investments, security prices will reflect the requirement for higher-than-average returns on higher-beta securities. Although it was originally developed for security markets, the CAPM also provides important insight into capital budgeting decisions of firms.