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CAPM

Explain accounting issues related to recognition of accounts receivable.

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CAPM

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  1. Capital Asset Pricing Model (CAPM)

  2. INTRODUCTION A widely-used valuation model, known as the Capital Asset Pricing Model, seeks to value financial assets by linking an asset's return and its risk. Prepared with two inputs -- The market's overall expected return and an asset's risk compared to the overall market -- The CAPM predicts the asset's expected return and thus a discount rate to determine price.

  3. Capital Asset Pricing Model • CAPM is an framework for determining the equilibrium expected return for risky assets. • Relationship between expected return and systematic risk of individual assets or securities or portfolios. • The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk • William F Sharpe developed the CAPM. He emphasized that risk factor in portfolio theory is a combination of two risk , systematic and unsystematic risk.

  4. ASSUMPTIONS • Can lend and borrow unlimited amounts under the risk free rate of interest • Individuals seek to maximize the expected utility of their portfolios over a single period planning horizon. • Assume all information is available at the same time to all investors • The market is perfect: there are no taxes; there are no transaction costs; securities are completely divisible; the market is competitive. • The quantity of risky securities in the market is given.

  5. The CAPM, despite its theoretical elegance, makes some heady assumptions. It assumes prices of financial assets (the model's measure of returns) are set in informationally-efficient markets. It relies on historical returns and historical variability, which might not be a good predictor of the future.

  6. CHARACTERISTICS - CAPM To work with the CAPM have to understand three things. • The kinds of risk implicit in a financial asset (namely diversifiable and non-diversifiable risk) (2) An asset's risk compared to the overall market risk -- its so-called beta coefficient (β) (3) The linear formula (or security market line) that relates return and β. Dr.P.S DoMS, SAPM, V Unit

  7. How is the CAPM derived? The CAPM begins with the insight that financial assets contain two kinds of risk. There is risk that is diversifiable - it can be eliminated by combining the asset with other assets in a diversified portfolio. And there is non diversifiable risk - risk that reflects the future is unknowable and cannot be eliminated by diversification.

  8. Implications and Relevance of CAPM • Investors will always combine a risk free asset with a market portfolio of risky assets. Investors will invest in risky assets in proportion to their market value.. • Investors can expect returns from their investment according to the risk. This implies a liner relationship between the asset’s expected return and its beta. • Investors will be compensated only for that risk which they cannot diversify. This is the market related (systematic) risk

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