Notesale: Turn your study into money

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‘The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the
industry even though it is based on very strong assumptions
...
’
"Modern portfolio theory teaches that a rational investment strategy requires an investor to
diversify the portfolio of investments" (S
...
This effectively provides the
substance in which our main assumption is established upon
...
No
pricing model holds the individual to account on this matter to the extent of the CAPM and
therefore leads us to the model's primitive and most decisive assumption: "investors are
rational and mean-variance optimizers" ergo investors consider the greater the risk involved
the great the reward accumulated
...
287, cited in Dawson, 2015)
...
CAPM
can be defined as a theory of the relationship between risk and return which states that the
expected risk premium on any security equals its beta times the market premium
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It is apparent
the CAPM has fundamental issues in its implementation, it's also clear that in practise the
CAPM is superior to alternatives
...
Various assumptions underlie the CAPM and rationalise its usage in the
industry
...
In this essay, I'll look
to give an account of the merits on both sides, weighing up and evaluating whether the
CAPM is still widely used taking into account the underlying assumptions
...

One of the main challenges that face CAPM and causes reason for scepticism in its
perceived market dominance stems from its relationship with beta
...
This is an important point as it correlates directly with our main assumption in which
investors expect higher returns based on the bigger risk associated with an investment
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Indeed, it can be said that if the relationship between beta and expected returns
hold, it's considered a positive aspect regarding CAPM's efficiency (F
...

Unfortunately, however, that tends not to be the case in the majority of examples
...
Numerous studies have been

conducted and have implemented data which has shown repeatedly that CAPM beta's that are
larger than other's in the subset have smaller excess returns
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The CAPM model predicts that beta is the
only reason that expected returns differ which isn't the case
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Comparatively, the CAPM model fails to register market
capitalisation
...
It's presupposed CAPM fails to
take into other variables, it equally doesn't take into account; earnings/price, cash flow/price
and past sales growth (F
...
The CAPM is also based upon other
assumptions, notably, investors are all susceptible to the same information regarding
investments, accordingly, implications to CAPM's failures in this area shouldn't be
overlooked, and certainly, the rate at which the model is used given the beta anomalies
should be questioned
...
On an evaluative pretext, due to its strong theoretical
standing, the three-factor model in Fama and French captures most of the average-return
anomalies missed by the CAPM (F
...
Furthermore, we look at the
disparity between the CAPM's performance regarding its estimate of expected returns and
that of the reward beta approach
...
Deliberating on the CAPM's (which is a one-period model)
assumption, the model states that the risk premium from any investment should lie on the
security market line (Brealey, et al
...
The CAPM tends to be
unsuccessful in this bearing, whilst the reward beta's approach increases monotonically from
left to right (Bornholt, 2007)
...
In the expected returns context, considering the
aforementioned assumptions, I question the CAPM's practicality and the premise it's still
used widely
...
“The
unconditional CAPM does not describe the cross section of average stock returns” (Lewellen
& Nagel, 2006)
...
e
...
e
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This is a
considerable adverse factor of the CAPM, and ultimately a flaw, as we revisit models such as
the three factor model of Fama and French in which states “the time-series regressions claim
that the size and book-to-market factors can explain the differences in average returns across
stocks” (F
...
Although beta’s do differ over time, they don’t alter
enough to have to explain observed asset-pricing anomalies (Lewellen & Nagel, 2006)
...
Size and book-to-market equity indeed proxy for sensitivity to common risk
factors in stock returns (F
...
There have nonetheless been recent

developments in the area, arguably providing explanation towards the flaws of the CAPM in
this regard, consequently offering solutions and promoting the CAPM as an advantageous
investment model, perhaps going some way to explain why it’s still widely used
...
What’s more, the CAPM assumes
that investors are risk-averse, with the CAPM indirectly failing to decipher value-premiums,
one may assume a risk-averse investor would limit its use of the model, rather turning to
industry alternatives
...
By its nature, the CAPM is used widely in the industry to calculate a required rate
of return for a company's investment project
...
In being
conceptive, "the CAPM will find a required rate of return which directly reflects the risk of a
specific project as opposed to the WACC, which ignores product risk" (Watson & Head,
2016)
...
Such is reasoning to understand and warrant the CAPM's high usage
in the industry
...
Embedded in the developments are extensions to the model which can be used to
rectify issues or perhaps combat difficult assumptions, in which the model is based on
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Taxes can create conditions in which
two investors can realise different after-tax returns from the same stock (Bodie, et al
...

A distortion which may lead to contrasting after-tax optimal risky portfolios for different
investors
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These extensions don't just combat assumptions, they also contribute to it's all
around efficiency and aid its industrial usage
...
(Cochrane, 2001, p
...
, 2011) notes, "An investor
must decide how much to save and how much to consume"
...
The
consumption-based CAPM is based on a homogeneous expectation assumption
...
The economic agents also have
homogeneous beliefs about the probability distribution of dividend and aggregate
consumption growth (Shi, 2016)
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, 2014)
...
In terms of
effectiveness, unlike the CAPM's measure of expected returns, a consumption-based CAPM
tends to follow the expectations of the pre-expected consumption and dividend growth
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Hereinafter demonstrating the usefulness of the model despite

its pre-established assumptions
...

It's conspicuous that the CAPM has both positive and negative qualities, likewise its evident
that there are variables in which the CAPM is unmistakably superior to any alternatives,
indeed there's evidence to suggest there are perhaps other models regarded as more
predominant
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I've explored individual behaviours such as rationality, mean-variance
optimisation, and homogeneous expectation, likewise I've considered market structure
assumptions relating to available information and taxation
...
This is also
proclaimed, considering the underlying assumptions the CAPM holds
...
To clarify, in my description of the CAPM's irregularities
with beta hence the emanation of beta anomalies, I spoke about the discretion between the
CAPM and that of the three-factor model of Fama and French
...
Fama & French, 1993), which is, of
course, a contradiction to the CAPM's main assumption which precludes that the amount of
expected returns received from an investment is directly linked to the security's beta
...
Indeed, these existing models incorporate suggestions to other fundamental
CAPM issues, by taking into account cross-section regressions, one can explain why high
book-to-market (growth firms) earns higher average stock returns than firms with low bookto-market
...
This comes through
measuring beta and separate time variables, in an expansion, (Cenesizoglu & Reeves, 2018)
ponders if you measure beta with short, medium and long run components the cross-section
of expected returns is explained just as well as the three-factor model for instance
...
, 2017)
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What's more "all recent developments in the area since the
CAPM has been published, have been the result of the search for additional that more fully
explain the relationship between risk and return" (Beal, et al
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Development's in the
area are based on creating better alternatives due to the flawed model, indicating that usage is
decreasing expeditiously
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Bibliography
Beal, D
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& Shamsuddin, A
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Introducing Corporate Finance
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Milton Queensland: John Wiley & Sons
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, Kane, A
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, 2014
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10th Global Edition ed
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Bornholt, G
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Extending the Capital Asset Pricing Model: the Reward Beta Approach
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69-83
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, 2013
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A Journal of Accounting, Finance and Business Studies , Volume 49, pp
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Brealey, R
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& Allen, F
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Principles of Corporate Finance
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New York: McGraw Hill Education
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, Myers, S
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, 2015
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8th Edition
ed
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Cenesizoglu, T
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, 2018
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Journal of Empirical Finance, Volume 49, pp
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Darrat, A
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& Park, J
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, 2011
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Journal of Banking and Finance, 35(8), pp
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Dawson, P
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The Capital Asset Pricing Model in Economic Perspective
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569-598
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Fama, E
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, 1993
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Journal of Financial Economics, 33(33-56), pp
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F
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& French, K
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, 1996
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The Journal of
Finance , 51(5), pp
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Lewellen, J
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, 2006
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Journal of Financial Economics , 82(2), pp
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S
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, 1995
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The Business Lawyer, 50(2), pp
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Shi, L
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Consumption-Based CAPM with Belief Heterogeneity
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30-46
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& Head, A
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Corporate Finance Principles and Practice
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Harlow: Pearson Education

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