Capm The Effects Of Beta

Background and Introduction

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.

Main Conclusions

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

EXECUTIVE SUMMARY 1

Background and Introduction 1

Main Conclusions 1

CAPM: THE EFFECTS OF BETA 3

A Financing Model 3

Flaws and Rewards 4

Beta - A Risk Indicator 6

What is Beta and Why it's Important to CAPM 7

Strengths & Weaknesses of Beta 8

Application: A Financial Manager's Toolbox 9

BIBLIOGRAPHY 11

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 + ОІ (Rm вЂ" Rf)

In the CAPM equation the expected return (R) is equal to the risk-free rate (Rf ) plus the product of beta (ОІ) and market-risk premium (Rm вЂ" 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).

Flaws and Rewards

The Capital Asset Pricing Model (CAPM) has been used for over 40 years. It is often preferred over other pricing models. Why is this? Do the rewards of using CAPM outweigh the flaws or risks? In researching the CAPM, many flaws to the model were pointed out. One person to point out flaws of the theory is one of its own developers, William Sharpe; who is revamping the original model.

The flaws of CAPM seem to be centered on the assumptions or expectations of all theories. In order to be an effective pricing theory, the model must be consistent with economic theory. The CAPM does not do this. Because the model follows a mean-variance approach, CAPM does not take into consideration the extreme economic circumstances such as depression or terrorist attacks. When using the mean-variance approach, a bell-shaped curve is plotted with the expected returns falling within the bell (normal distribution):

Extraordinary (rare) events, such as the ones described, fall in the �tail’ portion of the graph and are ignored by these types of formulas. The theory also does not take into consideration transactions costs and taxes which can diminish the amount the returns an investor realizes. This is noted to be a major flaw by Harry Markowitz, who won the Nobel Prize in economics along with William Sharpe in 1990.

Investors are not all the same. They differ in the amount of risk they are willing to take to what will be held in their portfolio (varying mixture of assets held). CAPM makes the assumptions that all investors are willing to assume the same amount of risk, have access to the same information concerning the market and assets (homogenous investor expectations) and that investors choose “assets solely as a function of their risk return portfolio” (http://www.answers.com). There is also the assumption that there are zero risk securities of varying maturities and in quantities sufficient enough