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Capital Asset Pricing Model (CAPM)

The capital asset pricing model “CAPM” is a model for pricing an individual security or a portfolio. The CAPM in it’s simplistic form takes into account expected rates of return as a function of systematic, non-diversifiable risk (its beta). The CAPM provides the foundation for the very complex Modern Portfolio Theory “MPT”.

The true test of a model lies not just in the reasonableness of it’s underlying assumptions but also in the validity and usefulness of the model’s prescription. In corporate finance applications, several potential sources of error exist in the CAPM:

 a) inadequate description of the behaviour of financial markets

b) betas are unstable through time, and

c) estimates of future risk free rates of return are often subjective

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