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Security Analysis and Portfolio Management
Notes
2.50 0.08
0.216 = +
P 1
0
2.50 0.08P 0
0.216 =
P 0
0.216 P = 2.50 + 0.08 P
0 0
0.216 P – 0.08 P = 2.50
0 0
0.136 P = 2.50
0
P = 2.50/0.136 = 18.38
0
11.7 Benefits and Limitations of CAPM
Benefits
CAPM model of portfolio management can be effectively used to:
1. Investments in risky projects having real assets can be evaluated of its worth in view of
expected return.
2. CAPM analyses the riskiness of increasing the levels of gearing and its impact on equity
shareholders returns.
3. CAPM suggests the diversification of portfolio in minimisation of risk.
CAPM is criticised for the following reasons:
1. In real world, assumptions of CAPM will not hold good.
2. In practice, it is difficult to estimate the risk-free return, market rate of return, and risk
premium.
3. Investors can estimate the required rate of return on a particular investment in company’s
securities.
4. CAPM is a single period model while most projects are often available only as large
indivisible projects. It is, therefore, more difficult to adjust.
11.8 Arbitrage Pricing Model
The Arbitrage Pricing Model (APM) looks very similar to the CAPM, but its origins are
significantly different. Whereas the CAPM is a single-factor model, the APM is a multi-factor
model instead of just a single beta value; there is a whole set of beta values – one for each factor.
Arbitrage Pricing Theory, out of which the APM arises, states that the expected return on an
investment is dependent upon how that investment reacts to a set of individual macro-economic
factors (the degree of reaction being measured by the betas) and the risk premium associated
with each of those macro-economic factors. The APM, which was developed by Ross (1976),
holds that there are four factors, which explain the risk/risk premium relationship of a particular
security.
Basically, CAPM says that:
E(R) = R + (R – R )
i f i m f
Where, is the average risk premium = R – R
m f
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