What is the CAPM and of what practical use is it Essay - 3

What is the CAPM and of what practical use is it - Essay Example According to CAPM, the expected return of a portfolio or a security is considered to be equal to the rate of a risk free security plus a premium for the risk factor. The risk factor is mainly calculated by taking a measure of risk called as beta in the model of CAPM. Beta is considered to compare the returns on a particular security to the market return. The formula for the CAPM is as follows: The development of the CAPM was mostly to explain the pricing of risky securities in the market. It is considered as a more practical approach to stock valuation as compared to the Markowitz theory which is considered to be more theoretical (Armitage, 2005, p. 51). The assumptions of the Capital Asset Pricing Model are as follows: I) It is considered that investors in general tend to maximize the utility of their wealth. The preferences of investors are taken into consideration through the concept of utility in the CAPM. Investors considered to be more willing to take risks are considered to have increasing marginal utility with regard to wealth while investors who are considered to be risk averse tend to have less preference for incremental wealth when it is considered to be associated with higher risk. II) It is considered that investors in general show similar expectations with regard to return and risk. It is considered in this regard that if investors do not have similar expectations, there will be no homogeneity in the conceptions of investors and as such no single efficient frontier line will apply to all investors. III) It is held that investors tend to make investment decisions on a rational basis depending on their preference for return and risk. Risk is considered to be mainly measured by two factors such as variance and mean. CAPM is considered to assume that rational investors tend to diversify away unsystematic