Topics: Capital asset pricing model, Investment, Modern portfolio theory Pages: 9 (2484 words) Published: March 19, 2015

The Capital Asset Pricing Model commonly known as CAPM defines the relationship between risk and the return for individual securities. CAPM was first published by William Sharpe in 1964. CAPM extended “Harry Markowitz’s portfolio theory” to include the notions of specific and systematic risk. CAPM is a very useful tool that has enabled financial analysts or the independent investors to evaluate the risk of a specific investment while at the same time setting a specific rate of return with respect to the amount of the risk of a portfolio or an individual investment. The CAPM method takes into consideration the factor of time and does not get wrapped up over by the systematic risk factors, which are rarely controlled. In this research paper, I will look at the implications of CAPM in the light of the recent development. I will start by attempting to explain and discuss the various assumptions of the CAPM. Secondly, I will discuss the main theories and moreover, the whole debate that is surrounding this area more specifically through the various critics of the CAPM assumptions. When Sharpe (1964) and Lintner (1965) proposed CAPM, it was majorly seen as the leading tool in measuring and determining whether an investment will yield negative or positive return. The model attempts to expound the relationship between expected reward/return and the investment risk of very risky assets by helping determine the required rate of return for any of the risky asset (Reilly and Brown, 2011). The CAPM states that, “the expected return on a security or a portfolio equals the rate on a risk-free security plus a risk premium” (Heshmat, 2012, p. 504). It further states that the expected return of an asset has a positive linear correlation with a security of a non-diversifiable risk i.e. beta (Heshmat, 2012). Further, Ushad (2011) argue that CAPM is majorly based on the assumption that higher returns are linked with the higher beta values. Therefore, years after the publication of the Capital Asset Pricing Model, and after comparison of the actual and the expected returns, many economists have since criticized the model based on its simplicity and the reality of its application (Banz, 1981). Although CAPM has been the foundation of many academic papers and non-academic financial community, the model is still subject to both empirical and theoretical criticism. However, despite the numerous criticisms, the model is still largely used by firms as an efficient and effective model for the calculation of the cost of capital. It’s calculated as:

E (Ri) = Rf + (E(Rm) - Rf) βi
Where, E (Ri) is the required return on the financial asset, i Rf is the risk-free rate of return
Βi is the sensitivity of the asset’s return to the market E (Rm) is the average return on the capital market.
Sharpe (1964) and Lintner (1965) proposed the various assumptions that the model must take into consideration. According to the Watson & Head (2007); Reilly & Brown (2011), the assumptions are; Investors can borrow or lend at the risk-free rate

All the unsystematic i.e. non-market risks are eliminated
Equal access to the securities in the market by all of the investors The transaction costs and the taxes are excluded
A standardized holding period is assumed by the in order to make comparable returns on the different securities. Thus the single-period transaction horizon. The financial applications of the Capital Asset Pricing Model are many. Indeed, the model is used in the valuation of the firm’s common stock, capital budgeting, mergers and acquisitions, and the valuation of the convertible stocks and warrants (Thomas & Francis, 1982). In the validation of the CAPM, William Sharpe (1964) made various assumptions for the investors in the creation of the market equilibrium. Moreover, the proponents of the CAPM argue that the capital market is operating “as if” these assumptions are satisfied. CAPM derives the amount of the price that any asset must pay so that the...

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