This summary provides a brief overview of Capital Asset Pricing Model (CAPM) as an alternative method for estimating expected returns. This paper also discusses the positive and negative effects of CAPM along with the risks of Beta and why this model has its share of drawbacks and critics in the marketplace. The first section will cover the basics of CAPM including its flaws and rewards. Next, the risks of beta and the strengths and weaknesses are discussed in conjunction with its relevance to CAPM and why it’s important to investors who are willing to take greater risks. Finally, an application is provided to show how beta affects CAPM from a financial manager’s perspective.
Despite the doubts about the validity of the CAPM formula, this model remains effective and widely used in the financial industry for determining expected returns and investment risk. There is only one beta used in the CAPM model and it serves as the full measurement of systematic risk and future cash flows. CAPM is not a perfect science nor do all investors agree on measuring the beta (risk) of an asset.
TABLE OF CONTENTS
Background and Introduction1
CAPM: THE EFFECTS OF BETA3
A Financing Model3
Flaws and Rewards4
Beta - A Risk Indicator6
What is Beta and Why it's Important to CAPM7
Strengths & Weaknesses of Beta8
Application: A Financial Manager's Toolbox9
CAPM: THE EFFECTS OF BETA
A Financing Model
The Capital Asset Pricing Model (CAPM) was published in 1964 by William Sharpe. CAPM derived from the workings of Harry Markowitz and his theory called the Modern Portfolio Theory. Later, in 1990 Sharpe, Markowitz, and Merton Miller won the Nobel Prize in Economics for their conceptualization of CAPM (Contingency Analysis n.d.). To date, CAPM has greatly influenced how investment portfolios are managed and it has even been claimed as one of the most well-known asset pricing model used in finance (Davis 2006).
The CAPM is a financing model used to assess the value of market portfolios by examining the relating systemic risk and the expected return. In actuality, the theory divides risk into two categories of risk, systemic and specific. Although, the CAPM only compensates investors for the systemic risk of the holding a portfolio since specific risk can be diversified away (Contingency Analysis n.d.). Risk in the CAPM is assumed as wanting to be avoided but if risk is accepted then investors expect to be rewarded, called risk premium. In addition to the risk premium paid to the investor, he or she will also be rewarded the risk-free return rate (Value Based Management 2008). Mathematically (CAPM formula), the amount an investor will be paid for his portfolio, taking into account risk, is:
R=Rf + β (Rm – Rf)
In the CAPM equation the expected return (R) is equal to the risk-free rate (Rf ) plus the product of beta (β) and market-risk premium (Rm – Rf) (Ross, Westerfield, & Jaffe 2007).
It should be noted, however, that the CAPM is valid under certain assumptions. First, as mentioned previously, this model assumes that investors are risk avoiders who want to maximize their wealth within the period. Specifically, the CAPM is a one period model. It also generalizes all investors as having the same belief on returns, they receive all costless information simultaneously, and there is a frictionless, perfectly competitive market. Next, it assumes there are risk-free assets that are without restraint and at a constant rate. It also does not take into account human capital, taxation, regulations, or restrictions on short selling. Incidentally, even though these assumptions and others are not usually met in reality, the CAPM still remains as one of the most widely used tools for determining expected return and risk when investing in market portfolios (Value Based Management 2008)....