Capital Asset Pricing Model

The CAPM is the device for explaining how markets evaluate capital assets, i.e. it explains how an efficient capital market sets a price on individual securities by taking into account their respective risks and expected returns from holding them (Neale, McElroy, 2004).
Fisher et al (2003) refer CAPM as a “model that relates the required rate of return for a security to its risk as measured by beta”. According to Ross et al (2002) “beta measures the responsiveness of a security to movements in the market portfolio”. But on the contrary to that fact, Pike and Neale (2006) argue that based on CAPM only the systematic risk is important when we are evaluating required risk premiums for securities, and “beta values reflect the sensitivity of the returns on the securities to movements in the market return “.
The CAPM Theory was developed by Sharpe and Linter in 1964-65.Four decades later, the CAPM is stillwidely used in applications, such as estimating the cost of capital for firms andevaluating the performance of managed portfolios.The CAPM builds on the model of portfolio choice developed by HarryMarkowitz (1959). The model assumes investors are riskaverse and, when choosing among portfolios, they care only about the mean andvariance of their one-period investment return. As a result, investors choose “mean-variance-efficient” portfolios, in the sense that the portfolios 1) minimize thevariance of portfolio return, given expected return, and 2) maximize expectedreturn, given variance.The portfolio model provides an algebraic condition on asset weights in mean-variance-efficient portfolios. The CAPM turns this algebraic statement into a test able prediction about the relation between risk and expected return by identifying aportfolio that must be efficient if asset prices are to clear the market of all assets (Fama, French, 1993).
Many experts criticized CAPM by admitting that it didn’t have the perfect and complete representation of the real world. In their famous... [continues]

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