Respond to the following: a. Describe the capital asset pricing model. b. What is the market model?

Question

What will be an ideal response?

Answer 1

ANSWER:
a. The capital asset pricing model has been developed for the theoretical pricing of individual stocks. Its first step is to relate the risk of an individual security relative to the market as a whole. The market is assumed to be a diversified portfolio. A correlation is made between the returns on individual stocks and the market returns over a period of time. Regression analysis is used to fit a line to a scattergram of these correlations. The slope of this line is called beta and represents a market-based measure of the systematic risk of an individual security relative to the average risk in the market as a whole. If beta equals 1, the returns are perfectly associated and the risks are equal. If beta exceeds 1, the returns on the individual stock are greater than the market.

The assumption of the capital asset pricing model is that individual securities are priced solely on systematic risk. Beta is used to predict the risk-based price of securities. A standard version of the capital asset pricing model defines the predicted rate of return for an individual security as a function of the risk-free rate of return, beta, and the expected return on the market portfolio.

b. Empirical studies in accounting use a simpler approach to the capital asset pricing model, the market model, in which the risk-free return is dropped and unexpected (or abnormal) returns for any time period are captured in an error term.