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.’

Developed in the early 1960s by Lintner (1965a, b), Mossin (1966), Sharpe (1964) and Treynor (1962), the Capital Asset Pricing Model (CAPM) analyses the relationship between the market price of an asset or stock, the risk it entails and the expected return to the investor (Sharpe, 1964). Since its publication, the CAPM has had a significant impact on the academic and non-academic financial community, with over one hundred academic papers using CAPM as a basis for calculating expected returns. The CAPM has numerous financial applications such as for capital budgeting and evaluating a firm’s common stock. and is also an effective model for firms in estimating cost of capital and evaluating the performance of managed portfolios (Naylor & Tapon, 1982).

With every model out there, there will be appraisals as well as criticisms. A principal advantage of CAPM is that it explicitly takes into account a company’s level of systematic risk relative to the stock market as a whole. The linear relationship between the required return on investment and its systematic risk is expressed graphically as the Security Market Line (SML). CAPM eliminated unsystematic risk, making it a simple and focused approach to calculating required return.

On the other hand, the CAPM has been subjected to theoretical and empirical criticism especially by several Economists, criticising its simplicity and the reality of its application. The invalidity of the CAPM is understandable as it was developed at a time when the theoretical foundations of decision making under uncertainty were relatively new and when basic empirical facts about risk and return in the capital markets were not yet known (Perold, 2004). For the CAPM to be valid, William Sharpe made several assumptions built for both the financial market and investors in creating market equilibrium.

First, this essay will briefly discuss the assumptions that enables CAPM to be utilised at optimum performance, as well as the...