The paper "Financial and International Markets" is a good example of finance and accounting coursework. The Capital Asset Pricing Model (CAPM) developed independently by Sharpe (1964), Lintner (1965) and Mossin (1966) assumed that asset returns are normally distributed and investors have mean preferences. Hence, it is possible to estimate expected returns, and thus cash flows, by adding an asset to a diversified portfolio. The asset in question is then sensitive to systemic risk (β , beta) as well as the expected return of the market and that of a risk-free asset.
This is expressed as [E(Ri) – Rf] / β = E(Rm) – Rf where E(Ri) is the expected risk of the asset, Rf is the risk-free asset, β is the sensitivity of the asset to the market, E(Rm) is the expected return from the market, often assumed to be the return from the market index and [E(Ri) – Rf], the difference between the expected return from the asset and that the risk-free return is the market premium. Thus, the risk from adding an asset comprises market risk, or systemic risk, or specific risk, which can be minimized by adding a large number of assets. Thus, theoretically, expected excess return may be estimated by regressing the following equation: [E(Ri) – Rf]t = α it + β [E(Rm) – Rf] - eit The average market return is usually assumed to be the historical return from the market index.
Hence, if the coefficient to the historical risk-free asset is estimated to be zero, that is investors can borrow at risk-free rates, then the expected excess return would be estimated to be sensitive to the market risk. However, empirical tests have found that the coefficient to the risk-free asset is not zero.
Besides, the model is not directly testable since historical returns may not be the same as future returns, the real structure of the market portfolio may not be known and the market index may not also be an appropriate estimation of the market portfolio (Trandafi). The CAPM model essentially rests on the assumption of normal distribution of asset returns, so that the variance of the returns appropriately measures systemic risk. However, empirical tests have shown that returns may not be normally distributed.
Further, investors are assumed to have rational expectations, capital markets perfect and that there are no asset arbitrage possibilities.
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