Capital asset pricing model Essay Example | Topics and Well Written Essays - 250 words

Capital asset pricing model - Essay Example Capital Asset Pricing Model is a tool extensively used to value assets in the financial sector. It has been extensively used in calculating the required return of investment products. The capital asset pricing model was introduced in the 1960s by William Sharpe; Required Return: Risk free rate + ? (Average Market Return –Risk free rate) Where ? is the beta value of the financial asset The basic assumptions of this model pose as disadvantageous for this model to be considered as a perfect representative of required return calculation. One of its basic assumptions is that investors are holding diversified portfolios that are emulating the average market return; implying that the unsystematic risk is eliminated from the risk versus return calculation of the investor. On the whole, investors do try and make diversified portfolios in such a way that it portfolio return complements or exceeds the market return. Therefore, this assumption is not a big concern and is fairly reasonable (Eugene, 2010). Another assumption is that it can only account for single period transition horizon and usually a single year is used for comparison between two securities. This is another reasonable assumption as investors usually quote returns on an annual basis even if they hold a security for a longer period (Eugene, 2010). The assumption that the average investor can borrow at risk free rate is misleading.