Capm Paper

The Capital Asset Pricing Model (CAPM):

What Is It? How Does It Work? And Does It Work Effectively?

In 1960, a doctoral candidate in economics at the University of California, Los Angeles by the name of William F. Sharpe needed a dissertation topic. After reading a 1952 paper on portfolio theory by Harry Markowitz entitled Portfolio Selection, Sharpe had found his idea. Markowitz's paper presented the notion of an "efficient frontier" of optimal investment that advocated a diversified portfolio to reduce risk. However, his theory did not develop a practical means to assess how various holdings operate together, or correlate. Sharpe took Markowitz's theoretical work and greatly simplified it by connecting investment risk and reward to a single risk factor (beta) (Burton, 1998). With the publication of his 1963 dissertation A Simplified Model of Portfolio Analysis, Sharpe introduced the world to the Capital Asset Pricing Model (CAPM). Today, CAPM has become an integral part of investment theory and is used on a daily basis by investment practitioners and managers. The concept was deemed so important that in 1990, Sharpe was awarded the Nobel Prize in Economics for his contributions to the development of the CAPM theory. Since its introduction, there have been many questions concerning the relevance of the assumptions upon which the theory is based. CAPM has been and continues to be tested within the academic research, however, although other alternative pricing models have been developed in an attempt to combat the shortcomings of CAPM, the Capital Asset Pricing Model is the most widely used and accepted model within the current financial community.

The Capital Asset Pricing Model is an economic model for valuing stocks, securities, and other assets by analyzing the relationship between risk and rates of return. CAPM has its basis in the idea that investors demand additional expected return called a risk premium, if they are asked to accept additional risk (http://www.valuebasedmanagement.net).

The model identifies two types of risk that investors face: 1) unsystematic or diversifiable risk, and 2) systematic or market risk. Unsystematic risk is risk specific to individual stocks that can be diversified away as the number of stocks within a portfolio increases. It is caused by random events such as lawsuits, strikes and other events that are specific to a particular firm. Systematic risks are market risks such as inflation, interest rates, and recessions that cannot be diversified away (McClure, 2006). Based on the analysis of risk, CAPM concludes that the relevant risk of an individual stock is the amount of risk it contributes to a well-diversified portfolio. In other words, a stock by itself is more risky than when that risk is diversified away within a larger portfolio. The stock still contributes some risk to the portfolio (the systematic risk), but through the diversification process, the unsystematic risk is removed.

CAPM is only valid as a model within a special set of assumptions. The Capital Asset Pricing Model is based on the following eight assumptions:

1. All investors focus on a single holding period, and they seek to maximize the expected utility of their terminal wealth by choosing among alternative portfolios on the basis of each portfolio's return and standard deviation.

2. All investors can borrow or lend an unlimited amount at a given risk-free rate of interest and there are no restrictions on short sales of an asset.

3. All investors have identical estimates of the expected returns, variances and covariances among all assets meaning that investors have homogeneous expectations.

4. All assets are perfectly divisible and perfectly liquid meaning that they are marketable at the going price.

5. There are not transaction costs.

6. There are no taxes.

7. All investors are price takers. This means that all investors assume that their own buying and selling activity will not affect stock prices.

8. The quantities of all assets are given and fixed (Brigham and Daves, 2004).

Few of these assumptions are rooted in the real world. Although these assumptions are neither valid nor met, CAPM is still one of the most used investment models in determining risk and return.

The formula for CAPM assumes that the return on an individual stock, or a portfolio of stocks, should be equal to its cost of capital. The formula which describes the relationship between risk and expected return is as follows:

The risk free rate is equal to the government T-bill rate. The equity market premium is the expected return of the market subtracted from the risk free rate of return. The equity market premium is then multiplied by the stock's beta coefficient (McClure, 2006). The beta coefficient represents the level of risk an individual stock contributes to the market portfolio.

Beta is a key concept within the CAPM model. The beta is the measure of a stock's volatility, or risk to the market. The overall market has a beta of 1.0 and individual stocks are ranked according to how far they deviate from the market. If a stock swings more than the market over time, it has a beta above 1.0. If a stock moves less than the market, it has a beta below 1.0. High beta stocks are considered riskier, but provide a potential for high returns, while low-beta stocks are less risky, but also have lower returns (McClure, 2004). If this is true, then a portfolio of low-beta securities will itself have a low beta, and conversely, a portfolio consisting of high-beta securities will have a high beta.

Interestingly, the CAPM is an ex ante model, meaning that all of the variables represent expected, future values. This is especially true of the beta coefficient. It should reflect the expected volatility of an individual stock's return versus the return of the market at a future period in time. However, beta is usually calculated using data from a period in the past and assumes that the stock's relative volatility will be the same in the future as it was in the past (Brigham and Daves, 2004). Beta is found by the statistical analysis of individual, daily share price returns, in comparison with the market's daily returns during precisely the same period.

In their 1972 study titled The Capital Asset Pricing Model: Some Empirical Tests, Fischer Black, Michael C. Jensen and Myron Scholes confirmed