Outline and discuss the Capital Asset Pricing Model (CAPM) as means of Essay - 3

Outline and discuss the Capital Asset Pricing Model (CAPM) as means of valuing securities and their risk. What are the drawbacks - Essay Example Some other financial experts like Lintner and Mossini also explained and purified CAPM and its interpretation in later years (Gassen, and Sellhorn, 2006). Capital Asset Pricing Model Being a quantitative tool for computing the yield of a security, CAPM is used for pricing the financial asset through mathematical calculations (Fields and Vincent, 2001). There are three main components of CAPM model which are stated as follows: Rf = Risk-free rate Beta = Risk of individual security with respect to market Rm – Rf = Market Risk Premium Risk-free Rate Risk free rate is considered as the rate at which the investor does not face any risk yet he obtains a specified return. This risk-free return can be obtained by investing in government securities which are considered are risk free. However, the term risk-free is referred to only the risk related to default risk. Since governments are considered as the ones which are not supposed to face default risk, therefore, their securities are c onsidered as risk-free securities (Babu, 2012). Beta Beta is the factor which indicates the risk of a particular security associated with the overall market risk (Vishwanath, 2007). ... This is the risk which is beyond the control of an investor as well as the corporations whose securities are being traded in the capital market. This risk is called as the overall market risk such that the whole market is exposed to that risk and bears its consequences (Berk and DeMarzo, 2010). On the contrary, unsystematic risk is the risk related to a specific security such as downfall in the earnings, or slow growth, heavy fine etc. This is the risk which does not affect the market and can be eliminated through diversification by adding more securities in the portfolio. Market does not reward unsystematic risk of a particular because this risk can be eliminated through diversification. But it does reward the systematic risk as this risk is faced by every security simultaneously in the whole market (Watson and Head, 2009). In a more concise manner, beta is the measure of systematic risk of the individual security with respect to market risk. In other words, it tells how much volati le an individual security is with the market volatility. Beta of the overall market is 1. So if the beta of the individual security exceeds 1, it means that the security is having more risk as compared to market risk. On the contrary, if the beta is less than 1, it means that the security is having less volatility as compared to market risk. A risk taker invests in those securities which have a beta of greater than 1 whereas a risk averse investor tends to remain at a safe side and invest in those securities which have a beta lower than 1. Market Risk Premium Market risk premium is actually the difference between the overall market return and the risk free return (Brigham and Ehrhardt, 2010). In other words, it is actually the excess return that market provides above the