The 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.’

Introduction:

The Capital Asset Pricing Model (CAPM) is a security pricing model developed by William Sharpe (1964), John Lintner (1965), and Fisher Black (1972). CAPM asserts that not all risks affect prices since some of these risks can be diversified. Moreover, it aims to explain the relationship between risk and return of risky assets. The expected return of an asset, according to the CAPM model, is equivalent to the rate of a risk-free security plus a risk premium, as outlined below:

E(Ri) = Rf + βi(E(Rm) – Rf)

where:

E(Ri) is the expected return on the asset.

Rf is the risk-free rate of interest (e.g. treasury bill).

βi is the sensitivity of excess asset returns to the expected excess market returns.

E(Rm) is the expected return of the market.

E(Rm) – Rf is the “market premium”.

E(Ri) – Rf is the “risk premium”.

According to Fama and French (2004), CAPM was built on Markowitz’s (1959) model, which assumes that investors are: (1) risk – averse and (2) will choose mean – variance – efficient portfolios, that is, the will maximize returns, while minimizing risks. Furthermore, Sharpe (1964) and Lintner (1965) added two key assumptions which state that: investors agree on the joint distribution of asset returns, and that there exists borrowing and lending at a risk-free rate (Fama and French, 2004). However, Black (1972) highlighted how borrowing and lending at a risk-free rate is not applicable in reality, instead allowing the unrestricted short-selling of risky assets. Fama and French (2004), on the other hand, find both models unrealistic since their absence would result in the inefficiency of market portfolios, which contradicts a fundamental assumption of CAPM and eradicates the relationship between expected returns and market beta....