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...