While it may not be the most efficient asset pricing model, due to reasons I will discuss further on, it is still widely regarded as the default model for asset-pricing in relation to risk. For this reason alone, I feel that the model merits a dedicated blog of its own. Agenda-wise, I will begin by explaining what the CAPM actually is and why its used, and then subsequently move on to analysing some other similarly relevant topics through both theoretical and practical examples. Once thats out of the way, I will then explore one of the main alternative models to the CAPM that can also be used to determine high risk asset prices, The Fama-French 3 Factor Model, and subsequently discuss why the former is used far more frequently than the latter. On an informal level, the CAPM can be defined as a model used by investors and financial managers to establish the required rate of return on investments in relation to the associated risk. In English terms, this means that the return on a specific security is equal to the current risk free rate plus the level of systematic risk proportional to its risk premium.
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As the access to this document is restricted, you may want to search for a different version of it. Sin-Yu Ho, More about this item Keywords capital asset pricing model ; CAPM ; risk ; market beta ; market portfolio ; literature review ; return on investment ; RoI ; asset prices. Statistics Access and download statistics Corrections All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:ids:gbusec:vyip
Does the Capital Asset Pricing Model Work?
The widely used capital asset pricing model CAPM —when put into practice—has both pros and cons. The capital asset pricing model CAPM is a finance theory that establishes a linear relationship between the required return on an investment and risk. The model is based on the relationship between an asset's beta , the risk-free rate typically the Treasury bill rate and the equity risk premium, or the expected return on the market minus the risk-free rate. At the heart of the model are its underlying assumptions, which many criticize as being unrealistic and which might provide the basis for some of its major drawbacks.
In the literature review, the author states that the CAPM has been the most favoured asset pricing model used since the s. The CAPM though, has been questioned and its misspecifications identified since the s, as the CAPM was unable to explain the risk measure and returns difference. Among the more notable risk measures identified, the author states, Basu found a positive connection between expected stock returns and earnings to price ratio. Following that, Banz concluded that small firms have, on average, higher risk-adjusted returns than large firms. Later, Bhandari showed a positive connection between debt to equity and expected stock returns, even when controlling such variables as systematic risk, firm size and the January effect.