# Practical use of the CAPM model - Investments

## Practical use of the CAPM model

One of the main areas of practical application of the theory of CAPM is the use of this model for the analysis of the future prices of individual financial assets and portfolios. Using the CAPM model, you can evaluate the potential "desirability" purchase of a security or a portfolio. For this, the investor needs to know three values:

1) risk-free yield r f (this can be considered the yield of government bonds with a maturity equal to the holding period);

2) the expected yield E ( r M) of the market portfolio (estimated using any RZB index);

3) βi i of the security or portfolio.

As follows from the theory of CAPM, if the price of a particular financial asset or portfolio adequately reflects the ratio of their profitability E (i> r i) and the risk of βi, then in conditions of financial markets equilibrium these funds or portfolios will correspond to the points on the line SML (points A and B in Figure 3.9).

Fig. 3.9. Using the CAPM model for analyzing the prices of funds

But in reality, the equilibrium of financial markets is not always observed. Therefore, there are dynamic deviations of the quantities E ( r i) from the equilibrium values. However, according to the theory of CAPM, financial markets should strive for equilibrium, as a result of which market mechanisms will lead to the elimination of dynamic deviations. It is this provision that is the basis for the practical use of the CAPM model.

Suppose, for example, that we are evaluating some financial means i (this may be a separate security or a portfolio). If you know the profitability of this tool for N calculation steps in the past, you can find its expected return:

This expected return will reflect all the dynamic deviations from the equilibrium values. Simultaneously, as you know, the expected yield can be estimated using the CAPM model:

This yield should be observed in the equilibrium of financial markets, when the risk of investing (more precisely, its systematic component) is estimated by the value , and the point on the graph corresponding to these values ​​of expected profitability and risk is located on line SML. If there is a dynamic imbalance in the financial market, i.e. for a given level of risk , the corresponding point is located above or below the SML line, and the market mechanism will affect in such a way that an equilibrium is established in the market and the following condition is met:

In order to correctly assess the changes that the expected return of the financial means must undergo, we introduce the conditional parameter :

If , then the financial asset under consideration is incorrectly estimated, and it is possible to predict the direction of changes in its market price and profitability.

Consider, for example, the point C lying below the line SML. This position indicates that at a given level of risk (determined by the value ) img src="/tp/images/pageimg/image603.jpg"> of the financial asset in question is too small in comparison with and . But this can happen only if the price of a financial asset is overstated and there is a dynamic market disequilibrium. The market mechanism will lead to the fact that investors will find these securities undesirable and will begin to offer them in large quantities for sale. As a result, the price will fall, and the expected profitability will increase, and in equilibrium this financial asset will be set at a price at which the ratio will correspond to the line SML.

The other situation corresponds to the point D: here, at a risk level the yield , defined by CAPM, and . But in this case, this financial instrument is underestimated. It is these securities that any investor strives to acquire, as they promise significant price gains. But the increased demand for such financial resources will entail an increase in their prices and, as a consequence, a decrease in the expected yield. In the end, at equilibrium, the ratio for this security will also correspond to the line SML.

So, using only three indicators: risk-free yield/y, expected return on the market portfolio and - beta coefficient " any i of the financial means, the investor is able, using the CAPM model, to determine whether he should: a) maintain this financial asset in the portfolio; b) sell it; c) buy a financial instrument.

The availability of the CAPM model allows you to give an initial forecast of the movement of the prices of financial assets. In carrying out a deeper analysis, it is necessary to take into account that CAPM is a model based on preliminary conditions, it describes events of a probabilistic nature, and the results of CAPM can not always coincide with the actually observed values. Therefore, it is advisable to estimate how accurately the CAPM model agrees with actual reality. However, it is not so easy to conduct such a check. One of the main difficulties in this case is the issue of the formation of the market portfolio and the calculation of , as well as . It is clear that the market portfolio should include all securities, but how to really assess its characteristics? The inadequacy of the answer to this question allows one to defend his points of view to both the supporters and opponents of the CAPM. For example, a number of studies conducted in the USA have shown that the values ​​calculated using linear regression relations do not coincide with the theoretical data from the CAPM model. However, supporters of the CAPM parry this criticism by the fact that the main parameters of the market portfolio were not adequately assessed.

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