1.
Introduction

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2.
CAPM

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3.
Global
CAPM

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4.
International
CAPM

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5.
Conclusion

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6.
Reference

The Capital Asset
pricing model, most commonly referred to as CAPM. According to the survey conducted
among the most successful US enterprises, 73-85% of the respondent claims to use
CAPM as their preferred methodology (Desai, 2005). Thus, CAPM is widely used
today to estimate the cost of equity capital. William Sharpe and John Lintner
won Nobel Prize in 1990 for their contribution towards CAPM theory. The CAPM
theory is built on Markowitz theory of mean- variance portfolio model and forms
the basis of modern portfolio theory.

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2.
CAPM

Markowitz mean- variance
analysis refers to the theory of combining risky assets so as to minimize
overall risk of the portfolio at desired level of return. The Markowitz theory
is based on three assumption i.e. all investors are risk averse and they
minimize risk for desired level of expected return or demand additional return
for additional risk, all parameter of individual asset like expected returns,
variance and covariance are known thereby all investors have same expectations
of all asset parameter and there are no taxes or transaction cost.

Sharpe and Lintner add
two key assumptions to the Markowitz model to derive CAPM i.e. all investors
are price takers i.e. individual buy and sell decision does not affect asset
price and investors can borrow and lend
at risk free rate and unlimited short- selling is allowed.

As all investors have
same expectation and all use mean- variance analysis, they all identify the
same risky tangency portfolio, the weight on each asset in the tangency
portfolio must be equal to the proportion of its market value to the market
value of its entire portfolio. CAPM compensates the investor only for taking
priced risk.

CAPM model is used to estimate the expected return
on a risky asset by adding to the risk free rate of return a market risk
premium. The expected return on the asset, as per CAPM, is measured based on
following formula,

E
(R

_{i}) = R_{F}+ β_{i}[E(R_{M}) - R_{F}]
Where:

E(R

_{i}) : the expected return on asset i
R

_{F}: the risk-free rate of return
E(R

_{M}): the expected return on the market portfolio
β

_{i}: Cov(R_{i}, R_{M})/Var(R_{M}), is a measure of the asset’s sensitivity to movements in the market_{ }
The CAPM described
above is also referred to as a domestic CAPM as all parameter consider as an
input are based on domestic environment i.e. to find expected return for US
security, the expected risk free rate on US treasury bonds is considered,
expected return on US market portfolio and beta is measured with respect to
securities traded on US exchange. This version of CAPM has its applicability
only in segmented market.

The assumption that the
investor consider only expected return, variance and covariance of asset in the
portfolio is not practical, as the investors also consider the relation of
their portfolio return with labour income and future investment opportunities
that would be offered by the market. CAPM assumes that all investor have same
portfolio, thereby implying that all investor have same time horizon for
holding a portfolio, which is not the practical case, as the time horizon for
the purpose of investment varies based on the liquidity need of the investor. Further, the assumption that all the investor
has access to same set of knowledge cannot be considered in isolation, as some
information is disregarded by investor if it falls beyond their investment time
horizon. In addition, the application of new / revised accounting rules may
have a short term impact on profitability and may affect the stock price. The
beta in CAPM measures the systematic risk in asset, the risk that cannot be
diversified away. At the time of applying CAPM, the beta considered is based on
past stock price volatility. However the future price cannot be solely based on
historic market price. There are other fundamental factors like profitability,
growth of the particular stock which also has impact on the security price.
Further, the demand and supply of the security on the traded exchange affects
the price of the security. Also, the stock beta varies over the time period and
period for which historic stock beta is considered also has an impact on the
derived expected value. Moreover, if there is a restriction on risk free
borrowing or lending and on short sales of risky asset, the relation between
expected return and beta will not be linear, thereby limits the applicability
of CAPM formula.

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3.
Global
CAPM

The global CAPM
advocates use of worldwide market index (e.g., the Morgan Stanley Capital
International World Index, MSCI) to compute market risk premium and the company
Beta employed would be based on global index.

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4.
International
CAPM

With globalisation, the
economies are integrated and relevance of domestic CAPM is reduced. International
CAPM (ICAPM) asserts that investors will hold a combination of risk free asset
of home country and world market portfolio hedged against currency risk. Thus,
for integrated market, ICAPM is more appropriate as ICAPM takes into
consideration the exchange rate risk by considering the sensitivity of asset to
all currency changes. Thereby, additional risk premium for each world currency
is added to standard CAPM formula. ICAPM states that the expected return on any
asset is sum of the investor’s domestic risk free rate, market risk premium and
a foreign currency risk premium for each foreign currency.

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5.
Conclusion

Many empirical studies
(Chan, Karolyi and
Stulz, 1992), (Mishra and O’Brien, 2001)
demonstrate that in integrated market there is influence of foreign market in
determining home country’s stock price, thereby suggest use of ICAPM or global
CAPM. However, there is no concrete evidence that claims superiority of latest
version of CAPM to determine expected return over traditional or domestic CAPM.

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6.
Reference

Desai (2005), ‘CAPM: The Challenge of
globalization’, pp.2