Capital Asset Pricing Model

Capital Asset Pricing Model has no practical value as it relies on many unrealistic assumptions”

Financial economist William Sharpe developed the Capital Asset Pricing Model. The model was introduced in Sharpe’s book; "Portfolio Theory and Capital Markets" in 1970. Sharpe was later awarded the Nobel laureate in economics in recognition of his work on this model.The CAPM theory concerns the way assets are priced, considering their risk. The CAPM was the answer to a question posed by Markowitz’s mean-variance portfolio model, of how to identify tangency portfolio. CAPM shows that risky assets equilibrium rates of return are actually a function of market portfolio covariance.

The model is as follows;

Ra= RF+ ОІa(RM-RF)

RF = Risk free rate

ОІa = Beta of the security

RM = Expected Market Return

ОІa is determined by the formula.

βa = ra – rf

(rm – rf)

Beta values can be trusted to be stable over time; therefore the value of beta can be taken from RMS (London Business School Risk Measurement Service) which uses historical data to calculate the value. These values however are only expected to remain representative for as long as the company maintains its attitude to risk. A change to the company’s characteristics, such as a takeover of a company in an unrelated industry, will cause the previous beta value to become inappropriate and unusable in the CAPM formula.

The CAPM theory states that investors should be compensated twice. Firstly the investor needs to be compensated for the time value of money. Would the money be better used in another situation? The risk-free (rf) rate in the formula represents the time value of money aspect to compensate the investors for investing money over a period of time. Secondly the investor needs to be compensated for the degree of risk involved by the investment. This risk is represented in the formulae by β(rm-rf) which calculates the amount of compensation due to the investor in regards to the additional risk taken on by the investor. The risk is calculated using the value beta. Beta is multiplied by the market premium (rm-rf), the asset’s return to the market, over a time period.

One key advantage of CAPM is its simplicity. It is a model that can be easily implemented by even the most inexperienced investor with good results. The model also consistently returns relevant and just results to a good degree of accuracy.

The formula is based around the value of beta. However the beta value is calculated using historical data, which although a good indicator, cannot predict the future with 100% accuracy.

Secondly there is no such thing as a “Risk free return”, with the closest alternative being a Government bond. However a risk free return is an underpinning factor of the CAPM. Finally it is impossible to accurately calculate rm, as no one can predict the return of a stock with 100% accuracy. The closest guide to this figure is taken from the FTSE index.

The model is fundamentally flawed as it is based on unrealistic assumptions. However it has been argued that if the assumptions are merely relaxed CAPM is particularly successful.

The model assumes that all investors have access to the same information and agree about the risk and expected return of all assets. (Homogeneous expectations assumption). The model also assumes that there are no taxes or transaction costs.

Empirical studies show a lower beta may result in higher returns than CAPM would predict. This was presented in 1969 in a paper by Fischer Black, Michael Jensen, and Myron Scholes. However this has been argued over the years.

CAPM assumes that all investors will prefer lower risk to higher risk. Certain investors may accept lower returns for higher risk and CAPM does not allow for this. It is possible that some stock traders will pay for risk similarly to a gambler in a casino.

Assumptions of CAPM

• All investors have rational expectations.

• There are no arbitrage opportunities.

• Returns are distributed normally.

• Fixed quantity of assets.

• Perfectly efficient capital markets.

• Investors are solely concerned with level and uncertainty of future wealth

• Separation of financial and production