CAPM (Capital Asset Pricing Model) and Its Practical Use Essay

CAPM (Capital Asset Pricing Model) and Its Practical Use - Essay Example It is carried out through a properly designed and professional model that does not require to be completely renewed on a case by case basis. It has, therefore, met the requirements of the Asset Management industry in which the capacity to correctly price securities, and to properly infer the right rate of return. These are used to determine traditional and innovative alternative assets and provide all qualities that can make possible for a portfolio manager to gain an early lead over competitors (Brigham and Houston). The model, from a technical perspective, has been based on the works of Dr Harry Markowitz, a widely renowned professional and researcher who had been able to conduct important studies and researches in the field of diversification and of modern portfolio theory. According to his studies, some fundamental proven hypotheses can be synthesized as follows: Harry Markowitz, Nobel Prizer, investigated the effects of correlation rates and of diversification policies and strat egies. As a result, he found that diversification in this sense, when correctly computed and carried out, can reduce and minimize the risk of a portfolio, together with an improvement of its required rate of returns. In this perspective, a Markowitz Efficient Portfolio has been defined as the portfolio where no added diversification can lower its risk for a given return expectation. In this sense, the ability to properly synthesize the main portfolio requirements is needed in order for a portfolio manager to meet the expectations and to reach the highest expected return. Once this efficient portfolio and its relative asset allocation is reached, no investor can minimize the risk further, and any departure from this allocation is perceived as something that impairs the risk level, and any asset added to the portfolio in this sense increases the risk level of the portfolio. An accurate selection of the most efficient portfolio, hence, can be reached through the analysis of the various possible portfolios of the given securities in the light of their degree of diversification. Dr Harry Markovitz also developed and implemented the so called â€Å"efficient frontier†, which represents the total and integral selection of the most efficient portfolios, analyzed on a risk return perspective. Under this view, the portfolios of assets that compose the efficient frontier are the ones that maximize return levels for certain given amounts of volatility (defined as risk). In this perspective, Harry Markowitz developed a mean Variance model that maximizes returns for given risk levels; the major assumptions of the model are the following: Investors tend to be rational Investors can easily determine the set of efficient portfolios highlighted above and can maximize their returns for a given level of risk There is a single period investment, as compulsory one for the analysis Risk of a portfolio is highly dependent on the variability of returns An investor prefers to in crease the consumption Investors are risk averse by their nature The utility function of investors has a concave shape Major technical aspects of this model make possible to infer some major behavioral characteristic: firstly, investors prefer to retain a portfolio with lower risk, for a given return level. In addition to this, for a given risk (and volatility) level, investors tend to prefer portfolios with higher returns (Markowitz). Investors can be defined as risk averse when their expressed main priority is to minimize risk, and therefore, choose portfolios with lower risk. While, on the other side they are believed to be rational when they prefer asset