The relationship between the future outlook of market risk and capital asset pricing

The most widely used Cost of Capital model is the Capital Asset Pricing Model. The Beta, Which is akey input into the model has proven to be unreliable and provides no correlation with systematicrisk. As risk increases, so should the cost of capital of the firm. The Beta is a historic measure of riskand does not capture the future outlook of risk. The future of an organisation and its risk may lookvery different to the past and therefore the need to calculate the Cost of Capital of a firm based onthe future outlook of the firm. The aim of this research was to analyse the different methodologiesused to determine the Cost of Capital of a firm in order to determine which models are better exante predictor of Cost of Capital in the South African context. Regression analysis was used to makestatistical inferences between the measure of risk used and the Cost of Capital model in question.The results of the research has shown that Market Capitalisation and Price to Book ratio are the bestproxies for risk when comparing it with the ex ante Cost of Capital models. However, the ThreeFactor Pricing Model is shown to be the best Cost of Capital model to capture the future outlook ofrisk. © 2010, University of Pretoria. All rights reserved. The copyright in this work vests in the University of Pretoria. No part of this work may be reproduced or transmitted in any form or by any means, without the prior written permission of the University of Pretoria. Please cite as follows: Van der Berg, GJ 2010, The relationship between the future outlook of market risk and capital asset pricing, MBA dissertation, University of Pretoria, Pretoria, viewed yymmdd < http://upetd.up.ac.za/thesis/available/etd-07172011-152729/ > F11/534/ag