Capital Asset Pricing Model

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.|

‘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.’

Sharpe and Lintner introduced CAPM and its development was greatly boosted by Jack Treynor’s early work. The CAPM is one of the economic theories that give a description of the relationship between expected return and risk and is used to price risky securities. The model perceives systematic risk as the only risk which rational investors price because the risk cannot be eradicated by diversification (Sharpe 1964, p.425: Linter 1965, p.13). The CAPM states that a security’s or a portfolio’s expected return is equivalent to the rate on a risk-free security added to a risk premium then multiplied by the systematic risk of an asset. In this sense, a high quantity of a security’s beta would result in a high-expected return of an asset and vice versa.

After CAPM was published, and after actual returns were compared with expected returns, many economists have since then criticized the simplicity of and the reality of application of CAPM. The CAPM is still subject to empirical and theoretical criticism despite it being the basis for over a hundred academic papers and having affected non-academic fiscal community considerably. Although it has an apparent invalidity, the CAPM is still widely used by companies as a valuable model for computation of capital cost through justification of high returns in correspondence to higher beta. Therefore, this paper will discuss the implications with regards to the current developments in the area. The paper will first explain and discuss various...