The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the industry even though it is based on very strong assumptions. Discuss in the light of recent developments in the area.
Sometimes your best investments are the ones you don't make." This maxim shows the complexity of investing.
In 1963, the finance journal article Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk introduced the foundations of the Capital Asset Pricing Model. The CAPM, initially proposed by Sharpe (1964) and Lintner (1965) has provided a simple and compelling theory of asset market pricing through the association of a portfolio investment to a single risk factor (the Beta factor).This theory predicts that the expected return on an asset above the risk-free rate is proportional to the nondiversifiable risk. In this sense the higher the quantity of beta of a security, the higher is the expected return of that asset.
In the years following the publication of the CAPM, and after comparing actual returns with expected returns, several Economists have criticised its simplicity and the reality of its application. Although the CAPM has been the basis for more than one hundred academic papers and has had significant impact on the non-academic financial community, it is still subject to theoretical and empirical criticism. Despite its apparent invalidity, the model is still commonly used by firms as an effective model for calculating cost of capital by explaining higher return in securities with higher betas. This paper will then discuss these implications in light of recent development in the area. First, I will attempt in this paper to explain and discuss the different assumptions of the model. Second, I will discuss the main theories and furthermore, the whole debate surrounding this area especially through the critics of the assumptions.
The financial applications of the CAPM are numerous. Indeed, it is used to value a firms common stock, for capital budgeting, for merger and acquisition analysis and the valuation of warrants and convertible securities. For the CAPM to be valid, William Sharpe made several assumptions for investors in creating market equilibrium. The proponents of the model argue that the capital market operates as if these assumptions were satisfied. The model derives what is the price that any asset must command in order for the investors to be happy to hold the current market portfolio (portfolio of all assets in the economy). In short, the model determines for X amount of market risk this is the expected return.
Under CAPM, everyone is bearing the same risk in different amounts. Investors hold diversified portfolios and they will require a return for the systematic risk of their portfolios since unsystematic risk has been removed and can be ignored. An investor will then rank a portfolio according to a utility function which depends on this portfolios expected rate of return. Since everybody holds the same portfolio of risky assets; it is ordinary that everybody is exactly happy to buy the market portfolio (the portfolio of all assets that are being offered on the market).
Moreover, it is possible to diversify part of the risk through the purchase of many different assets. The riskiness of a stock is not essentially related to the variability of its return. The variability would be the appropriate measure if one investor is putting all his money in a single asset. In reality, it is possible to diversify part of the risk through the purchase of many different assets.Indeed, through diversification, it is possible to eliminate the risk that is unique to individual stocks but not the risk that the marke