Text Preview

In financial sector, a fundamental question for any fund manager is how to estimate correctly their equity investment. The Capital Asset Pricing Model (CAPM) and Beta can be used to provide comprehensible answer for this question. According to the earlier study of Markowitz (1952), Sharp (1964), Lintner (1965) and Mossin (1966) have developed CAPM as a key portfolio management model that referring to the relationship between expected return and risks of assets. Based on the CAPM, the return of the portfolio consists of two components such as: the risk-free rate of return and the compensation for taking on risk. The risk-free rate is a rate of return of safe investment (i.e. government bond or 1 year-Treasury bill). The compensation or excess return on equity depends on two things: (i) a measurement of the portfolios risk Beta, and (ii) the market risk premium. Specially, beta is the key components of CAPM. It is a risk measurement, introducing the extent to which the sensitivity of a single security’s return responds to variation in return of stock market. By using effective CAPM and Beta, the investment managers can achieve a higher return for a specified acceptable level of risk. Nonetheless, there are several debates about the usefulness of CAPM. Therefore, the first and second part of this essay will focus on exploring the advantages of using CAPM and Beta to help fund manager obtain optimal asset portfolios and the underlying problems of the model respectively. Finally, after in-depth analysis of the key problems of the CAPM, the possible solutions to overcome such shortfalls of the CAPM will be made. 1. The advantages of Beta and CAPM

According to Bodie et al 2011, Brealey et al 2011, Fama and MacBeth (1973) , the CAPM play a particularly important role in assessing security portfolios in term of mean-variance preferences. There are various reasons that lead the CAPM to be dominant among other models. First, it is simple to understand and easily accessible in the absence of information. Makiel (1995) argues that fund managers can use the CAPM to obtain the market return by distinguishing the difference between expected and residual return. Second, investors can reduce overall level of risk faced by holding fully diversified portfolios since the variance of return of a portfolio is less than the average of the risk of single investment. Third, fund managers can estimate the value of a share is more or less volatile than the market itself through calculating the CAPM. In particular, the investment will be considered to be accurately price if it’s expected return matches the one according to the CAPM. Conversely, if the expected return of the investment differs from the forecasted return of the CAPM, the investment may be either underpriced or overpriced. Fourth, the CAPM’s Beta is an effective estimation for risk to understand about a security that investors are planning to add to their portfolio. For example, securities which are riskier than average will have betas that exceed 1, and securities that are safer than average will have betas that are lower than 1, the riskless securities will have a beta of 0. 2. The drawbacks of the CAPM and Beta.

3.1. Assumption

Although the CAPM is a popular tool to manage portfolio, it does have its problems. The model is based on the assumptions that are criticized as being idealized and unrealistic as well. Roll (1977) emphasizes that it is impossible to test the application of the CAPM due to there is no accurate benchmark about the market portfolio. In other words, if investors do not identify the market portfolio correctly, using the method can lead they underestimate their required return and therefore cost of common equity. However, Bodies (2011) state that the model could not be solve without assumptions. Although they are theoretical, they...

## Share this Document

Let your classmates know about this document and more at StudyMode.com