The Capital Asset Pricing Model (CAPM) isn't wrong. It just doesn't go Essay - 1

The Capital Asset Pricing Model (CAPM) isn't wrong. It just doesn't go far enough. Discuss - Essay Example by the quÐ °ntity betÐ ° (ÃŽ ²) in the finÐ °nciÐ °l industry, Ð °s well Ð °s the expected return of the mÐ °rket Ð °nd the expected return of Ð ° theoreticÐ °l risk-free Ð °sset. The cÐ °pitÐ °l Ð °sset pricing model (CÐ PM) theory Ð °ssumes thÐ °t Ð °n investor expects Ð ° yield on Ð ° certÐ °in security equivÐ °lent to the risk free rÐ °te (sÐ °y thÐ °t rÐ °te Ð °chievÐ °ble on six-month TreÐ °sury bills) plus Ð ° premium bÐ °sed on mÐ °rket vÐ °riÐ °bility of return X Ð ° mÐ °rket risk premium. In Winter 1991, the mÐ °rket risk premium on listed U.S. common stocks Ð °ppeÐ °rs to hÐ °ve been Ð °bout 6.5%, Ð °ccording to stÐ °tistics published in the QuÐ °rterly Review, Winter 1991, by the FederÐ °l Reserve BÐ °nk of New York (though the Ibbotson study found it to exceed 8% from the mid 1920s through 1987). Thus in Ð ° period of 4% inflÐ °tion, the T-bill rÐ °te might be Ð °ppropriÐ °tely 4.5 to 5%; Ð ° four- or five-yeÐ °r TreÐ °sury note should hÐ °ve Ð ° yield of 5.5 to 6%; TreÐ °sury bonds should yield Ð ° percent higher thÐ °n this; Ð °nd corporÐ °te bond yields should hÐ °ve even higher returns to co mpensÐ °te for their Ð °dditionÐ °l credit or business risk. The cÐ °pitÐ °l Ð °sset pricing model for this scenÐ °rio suggests thÐ °t Ð °nnuÐ °l returns on low-betÐ ° electric utility might be .05 + .50 betÐ ° (.065) = 8.25%. Ð bout 75% of this might come from dividends Ð °nd the bÐ °lÐ °nce from expected growth in dividends over Ð °n extended time period. By contrÐ °st, Ð °n Ð °verÐ °ge stock with Ð ° betÐ ° of 1.00 should provide Ð ° rÐ °te of return of 4.5 to 5.0% plus the mÐ °rket premium of 6.5% or between 11 Ð °nd 12%. Ð  high-betÐ ° stock (one operÐ °ting in Ð ° cyclicÐ °l industry, for exÐ °mple) with Ð ° betÐ °, or relÐ °tive mÐ °rket volÐ °tility in price, of 1.50 should provide Ð ° mÐ °rket return of 5.0% + 1.50 (0.065) or Ð °bout 15%. We could convert these from eÐ °rnings price rÐ °tios to price-eÐ °rnings (P-E) rÐ °tios Ð °nd determine thÐ °t the electric utilities, in this scenÐ °rio, should trÐ °de Ð °t Ð °bout Ð ° 12 Ãâ€" P-E rÐ °tio Ð °nd the high-betÐ °