The Capital Asset Pricing Model

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In the following essay I will be comparing and contrasting the effectives of the capital asset pricing model (CAPM), Arbitrage Pricing Theory, and the Fama-French three factor model when estimating the cost of capital and explaining performance of investment portfolios.

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.

Guermat (2014) states that the results of CAPM are always correct in a technical sense however, whether it is accurate to reality is questionable. I argue that we can only achieve an effective result if variables such as beta and expected returns are

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