what is the capm theory?

 R a = R r f + β a ∗ ( R m − R r f ) where: R a = Expected return on a security R r f = Risk-free rate R m = Expected return of the market β a = The beta of the security begin &R_a = R_ + beta_a *left(R_m – R_ right) &textbf &R_a = text &R_ = text &R_m = text &beta_a = text &left(R_m – R_ right) = text end ​Ra​=Rrf​+βa​∗(Rm​−Rrf​)where:Ra​=Expected return on a securityRrf​=Risk-free rateRm​=Expected return of the marketβa​=The beta of the security​

E ( r I ) = R f + β I ( E ( r m ) − R f ) where: E ( r I ) = return required on financial asset I R f = risk-free rate of return β I = beta value for financial asset I E ( r m ) = average return on the capital market begin&E(r_i)= R_f + beta_i(E(r_m)-R_f)&textbf&E(r_i)=text I&R_f=text&beta_i=texti&E(r_m)=textend ​E(ri​)= Rf​ + βI​(E(rm​)−Rf​)where:E(ri​)=return required on financial asset iRf​=risk-free rate of returnβI​=beta value for financial asset iE(rm​)=average return on the capital market​

Although the APT is an alternative to CAPM, it has fewer assumptions than CAPM and can be more difficult to implement. Ross developed the APT on the basis that the prices of securities are driven by multiple factors, which could be grouped into macroeconomic or company-specific factors. Unlike the CAPM, the APT does not indicate the identity or even the number of risk factors. Instead, for any multifactor model assumed to generate returns, which follows a return-generating process, the theory gives the associated expression for the asset’s expected return. The CAPM formula needs to input the expected market return. However, the APT formula takes into account the asset’s expected rate and risk premium from multiple macroeconomic variables. Racheal Dickens (Xiamen China), last updated 9 weeks ago

It is harder to find a value of the equity risk premium. A stock market’s return is equal to the average of all the returns. Capital gain Average dividend yield. A stock market could provide a negative return rather than a good one over the short-term if falling share prices are greater than the dividend yield. Although it is common to base an ERP value on empirical research over the long term, the ERP has not been proven stable. Current UK standards consider an ERP value between 3.5%-4.8% to be reasonable. Uncertainty about ERP values can introduce uncertainty to the value of the return calculation. Modified by Nikeya Gooff, June 25, 2021

Based on an article by hbr.org, an important task of the corporate financial manager is measurement of the company’s cost of equity capital. Estimating the company’s equity cost can cause a lot more head scratching. Often, the results are subjective so they cannot be used as reliable benchmarks. The article offers a way to arrive at this figure. It was developed in the rarefied world of financial theory. It is called The capital asset pricing model CapM is an idealized depiction of how capital markets price securities, and thus determine the expected returns. It provides an approach to quantifying risk, and translating it into estimated returns on equity.

Cfainstitute.org Continued to say that the three factor model captures variation in asset returns which the CAPM does not. According to behavioralists, violations of the CAPM are due to irrational pricing which the three-factor model captures with the B/M. However, it’s difficult to say whether the difficulty in explaining returns is due to irrational prices or rational pricing in an incomplete modelling. The lack of empirical or theoretical clarity about what makes up the market portfolio is making it difficult to test the CAPM. Many argue it’s impossible to test CAPM. This is because empirical data test whether market portfolio proxy functions well, but they don’t tell anything about CAPM. In an attempt to identify a proxy that is reasonably efficient, efforts have been made to expand the market portfolio beyond stocks to international assets. The market proxy still isn’t effective because it adds the B/M as well as other variables to regressions effectively annuls the CAPM-predicted beta–expected return relationship. Raman Bartley, February 25, 2021.