The Capital Asset Pricing Model (CAPM)

In this literate review the most important papers about explaining stock returns from 1952, when Markowitz came up with Modern Portfolio Theory, till around 2011 will be discussed. As stated in Chapter 2, Jack Treynor was one of the first economists that started to work on the CAPM model. When he developed the CAPM in 1961, there was no way yet to fully test it. Because there were no samples large enough or of sufficient quality, the real testing of the CAPM started in 1970. In 1973, the world was shown the famous Black and Scholes options pricing model. One of the first studies that gave a different answer than the CAPM was the research by Basu (1977). While he agrees with the Efficient Market Hypothesis, Basu reaches another

CAPM is Capital Asset Pricing Model. The CAPM formula shows a linear relationship between the expected return and systematic risk (Brealey, Myers and Allen, 2011). The formula is:

The CAPM is a single factor model because it based on the hypothesis that required rate of return can be predicted using one factor that being systematic risk. It looks at risk and rates of returns, compares then to the stock market providing a usable measure of risk to help investors determine what return they will get for risking their money in an investment. There are a lot of assumptions and drawbacks of CAPM that lead to the conclusion that those investors utilizing this

Using CAPM to provide the calculation for the equity, this presents both positive and negative effects.

So, the cost of capital of any investment opportunity equals the expected return of available investments with the same beta. This estimate is

Investors hold diversified portfolios : One of the assumptions of CAPM model is that investors are holding only portfolios which are subjected to systematic risk , the unsystematic risk can be ignored , therefore the unsystematic risk has been ignored (Lakonishok & Shapiro , 1986)

So the investor will invest 81.76160279% of the investment budget in the risky asset and 18.23839721% in the

Even though there are flaws in the CAPM for empirical study, the approach of the linearity of expected return and risk is readily relevant. As Fama & French (2004:20) stated “… Markowitz’s portfolio model … is nevertheless a theoretical tour de force.” It could be seen that the study of this paper may possibly justify Fama & French’s study that stated the CAPM is insufficient in interpreting the expected return with respect to risk. This is due to the failure of considering the other market factors that would affect the stock price.

According to early academic researches, CAPM seems to have some problems when examining assumptions and empirical testing. Researchers attempt to develop a new model by improving the weak points and make it more realistic which enable investors understand more about financial market situation. Bodie et al. (2014) state that multifactor model could provide better explanation of security returns. Merton (1973) develop ‘Intertemporal model’ to imply that by using beta as a risk measure alone might not yields efficient results in the real world. Therefore, he suggests that other factors could be involved in the calculation. It is clear that he suggests investors to consider not only market risk but also extra market source of risk. Moreover, he mentions that CAPM has a limitations on the economic way of thinking because there are two important factors which are income and many consumption of goods are not be considered. These two factors are changing over time and relative to price.

In order to maximize a portfolio’s return, it is important to analyze risk and diversify securities, while adhering to the goals of an investor. Through analyzing the different classes of risk, one can match investments to an investor’s risk tolerance and return requirements. Even though some investments may present greater risk they are countered by a higher rate of return and vice versa, less risk corresponds to a lower return. Moreover, investment risk can be substantially reduced through diversification, which spreads a portfolio across different industries, businesses and investment options. The makeup of a diversified portfolio continually changes based on an investor’s time horizon and investment goals. In accordance with the Modern Portfolio Theory (MPT), one can maximize return while reducing risk, through assessing investments standard deviation and beta. When applied to the capital asset pricing model (CAPM) an investor can determine what the expected rate of return should be and if the risk is worth it. Therefore, by analyzing risk and diversifying investments one can maximize an investment growth, increasing a portfolios return.

Beta is a measure of the market risk of a security or a portfolio in comparison to the market as a whole. It is used in the Capital assets pricing model (CAPM), which calculates the expected return, and assets based on its beta and expected market returns. The market beta is set at 1.00 and every stock is calculated by value line based on past stock price volatility. A beta of less than 1 indicates that the security will be less volatile than the market whereas a beta greater than 1 indicates that the security price will be more volatile than the market.

A diversifiable risk can be taken to be a price change risk as a result of circumstances that are largely unique in regard to a given security in contrast to the entire market (Focardi & Fabozzi, 2004). On the other hand, an un-diversifiable risk can be taken to be a risk which affects a given asset class or liabilities in their entirety.

The capital asset pricing model, also called CAPM, is created by William Sharpe, John Lintner, Jack Treynor and Jan Mossin in 1964, aiming to study the decision process of security price in the market. With proper assumptions on investors’ behavior, the capital asset pricing model pays the most attention to the exploration of quantified relationship between security return and the risk. However, academic community is turning away from the classical model and tries to analyze the relationship with other tools. This essay will mainly discuss the reasons why academic community is avoiding the CAPM. In addition, the relationship between risk and return will firstly be explained. More details on fundamental features of the CAPM will be given out. Empirical evidence will be adopted to illustrate the CAPM.

The CAPM model was developed by Sharpe (1964) to explain how capital markets set share prices. (Pike and Neale) In result of research by Sharpe (1964), Litner (1965) and Black (1972) the Capital Asset Pricing Model (CAPM) states “the relationship between beta (measure of volatility on portfolios/assets) and expected returns is linear, exact, and has a slope equal to the expectation of the market portfolio excess return”. CAPM makes the assumption that markets are efficient therefore suggesting that operators within the market have rational expectations, this assumption leads us to the first weakness of CAPM (Vernimmen, 2011). However, when estimating the cost of capital, CAPM is seen to be preferred compared to other asset pricing models simply due to its simplicity. In a survey conducted by the Association for Financial Professionals (2011) it was found that when estimating the cost of capital 87% of all firms and 91% of publicly traded firms used CAPM.

|2 |Beta |The sensitivity of the asset's returns to market returns, its non-diversifiable risk, its systematic |