The model also considers the markets expected return and the theoretical risk-free assets expected return. CAPM draws from the portfolio theory developed by Harry Markowitz (1959). The formula of calculating expected return of an asset portfolio using the CAPM model is given as E(Ri) = Rf + β (E(Rm) – Rf) where E(Ri) is the expected market return. Rf is risk-free rate of return; β is the sensitivity of the excess returns of the assets to the excess market returns; E(Rm) is the expected market return; E(Rm) – Rf is the market premium which represents the difference between expected rate of return in the market and the risk-free rate of return; and E(Ri) – Rf.
In terms of risk premium, this formula can be restated as E(Ri) – Rf = β i(E(Rm) – Rf). This means that the individual asset premium is equal to the market premium multiplied by β . There are various theories, empirical studies, and developments which explain the Capital Asset Pricing Model. Fama and French (2006) suggest that CAPM is attractive because it provides powerful and pleasing predictions about the measurement of risk and clearly explains the relationship between risk and return of assets.
According to Perold (2004), the price of a highly risky asset should be low in order to earn high payoffs in the future relative to the initial price of the asset (Ross 1976). However, this faces difficulties when the risk of the asset results from how the asset is held. Diversification is used by firms to reduce risk (Kothari et al, 1995). The essence of diversification is that one is able to spread his/her wealth across several independent risks so that they can cancel each other when held insufficient number (Sharpe 1964).
This results in the investment in a diversified portfolio in order to minimize risk in the firm. CAPM enables investors to find the correlation among individual security returns and how such returns affect portfolio risk (Graham & Harvey 2001). According to Markowitz, diversification relies on the imperfect correlation of individual risks, and the reduction of risk through diversification depends on the extent of correlation between individual asset returns.
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