Capital Asset Pricing Model is rationalized by modern portfolio theory to determine the fair value of an asset. Due to it’s reliance on assumptions on an investors behaviours, the distributions of risk and returns it’s measurements are open to scrutiny from independent analysis. Therefore, when using the CAPM to evaluate your portfolio model, you should have a third party evaluate your analysis. The principles of CAPM and the efficient frontier allows you to set expectations when you place assets in your portfolio, in particular correlations between the return on investment for high risk assets.
What is the CAPM?
Poses to explain the correlation between identifiable risk and expected return of an asset or particular-kind of assets within the sector or wider market. It is an attractive method of pricing assets and attributing return on investment to riskers assets within the market.
So as ER = expected return on
Rf = the risk-free rate
Bi = Beta of the investment
(ERM – RF) = market risk premium
The first assumption that you should present is that you are to be compensated for TVM of a minimum and secondly that you will be rewarded for taking on the risk since the risk-free rate accounts for TVM.
The market beta for the asset shows the risk of the asset and the impact of that risk the asset will have when added to the portfolio, in addition to the risk considered vs the overall market. For a beta greater than 1.0, it has a higher risk than the wider market and therefore should attract greater returns. For a Beta with less than 1.0 it should provide lesser returns but grant stability to the portfolio.