Capital Asset Pricing Model: Recent Developments and Criticisms

This essay analyses recent developments in Capital Asset Pricing Model (CAPM) and its criticisms. It discusses the assumptions and limitations of the model and explores alternative models. The essay concludes that while CAPM is widely used, it has several limitations and should be used in conjunction with other models.

Running head: STRATEGIC FINANCE
Strategic Finance
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Introduction:
The Capital Asset Pricing Model (CAPM) serve as an important tool and is employed
broadly within the international industry as it is relied in extremely strong estimations. In
light of recent developments in this topic a detailed development within the area. Whether
this model is credible model for analysing risks along with anticipated return has attained
high academic and professional elaboration. Aggarwal (2017) explained CAPM to be a
theory of relationship between risk and return which indicates that the anticipated risk
premium on certain security is identical to its beta times the market risk premium. The
CAPM serves as a highly renowned technique employee because of its capability to account
for systematic uncertainty in comparison to the unsystematic ones in order to decrease the
diversification impacts on anticipated returns. This is for aa particular shareholder after being
added to an investor’s well-developed portfolio.
The CAPM employs beta in order to signify the “sensitivity of a stock’s return to the
market portfolio return. The CAPM also indicates that the cost of equity capital of the
investor’s is determined by the beta (Akpo, Hassan and Esuike 2015). Such beta is also
multiplied by the market risk premium that is the difference between treasury bill returns and
anticipated market return. This facilitates in computing the asset’s risk premium, decreasing
the impacts of diversification on the expected return of assets that facilitates in computing the
systematic risk through adding a particular asset to an established well-developed portfolio.
The risk premium is then added within the risk-free rate or the return rate related with
treasury bills. The security market line explains the association among the beta and expected
return.

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Concepts behind the problem and discussion:
Baker and Wurgler (2015) revealed that CAPM is implemented by the portfolio
manager in supporting the investors to decide their portfolio through carrying out equity
capital computation of the organization. For this reason, it can be said that this technique
facilitates expected decay quantification and this facilitates conversion of likely uncetainities
related with anticipated return on equity. The CPAM theory is observed to have several
assumptions that is considered at the time of computing anticipated risk returns that is
attained by securities. One of such assumption is that the financial market includes numerous
investors those are well-informed, educated as well as prudent sellers and buyers. Another
assumption is that that the investors are highly concerned regarding their money and
anticipated to attain a premium or additional uncetainities they assume at the time of
investment (Barberis, Greenwood, Jin and Shleifer 2015). Third assumption considers that
investors deemed to be moving ahead towards a same duration for investment planning.
Fourth assumption is that less taxes and concessions along with commissions are applicable
and it is also assumed that there is a single tax-free rate and investors lend or borrow in a
particular rate.
Barillas and Shanken (2018) revealed certain criticism as is present over the validity
of CAPM in ensuring a needed return rate that is used commonly and the work of
“JohnLintner, Jack Treynor, William Sharpe and Jan Mossinis” are considered as among the
most vital financial theories prepared. Nobel prize was awarded to William Sharpe in
Economics in the year 1990 for his work accomplished with CAPM. There have been several
extensions to the CAPM as it was initially developed that has made the model that is highly
complex and this is slightly highly accurate. Most of the criticism related with the original
CAPM exist in the basic anticipations. Several critiques have also argued that there are
several assumptions and numerous assumptions among them are observed to be highly

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presumptuous. Among the most renowned CAPM critiques such as Berk and Van Binsbergen
(2016) which argues that it is virtually impossible to attain a real market portfolio along with
the past and current empirical model testing is inappropriate. These reasechers also argued
that the CAPM can be considered identical to testing of an asset’s mean variance
effectiveness.
In contrast, Fama (2014) stated that it is not possible to test aa market’s mean-
variance effectiveness in case of an unobservable market. The reasechers have also
considered that for maintaining aa genuinely diversified portfolio it can also consider all the
investments in all the assets in all the industries internationally. For this reason, the empirical
tests employed for the CAPM are not enough for they employ “insufficient market proxies”
that includes DAX and FTSE 100 which do not consider all the financial asset types into
account for this might be unobservable. It was evidenced by Jarrow (2018) that ineffective
marketing proxies are employed in CAPM in which a manager with “suitable capability”
might be deemed as inferior for a manager with less than perfect capability in case they
employ an ineffective market proxy focussed on mean-variance.
Kristoufek and Ferreira (2018) recognised that the CAPM model implementation has
several advantages that facilitates the investors in deciding the securities to acquire and in
developing an efficient and profitable portfolio. One of these advantages includes that the
calculations provided by this model is easier and stress tested that offered a broad range of
results. This further facilitates in developing confidence among the investors in investing
within an effective portfolio. Moreover, existence of a diversified portfolio facilitates in
decreasing the unsystematic uncertainty. Another advantage that is offered by
implementation of CAPM model is that it considers the systematic risk (Akpo, Hassan and
Esuike 2015). In such condition it is vital to consider that the identified risk is unforeseen that
must not be neglected and can form a part of risk evaluation theory. For this reason, this

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technique is deemed to be highly reliable that ensures comparison of organizational
performance with account for market performance. Kuehn, Simutin and Wang (2017) also
indicated that CAPM is also advantageous for investment portfolio appraisal as the offered
discount rate is higher than those provided by other models. For this reason, it maintains a
good link between expected investor returns from his investment and systematic risks of the
same.
Figure 1: SML Plot
(Source: Lee, Cheng and Chong 2016)
The Security Market Line (SML) can be understood as a line that correlates the return
on investment attains in association to the attached risks. From the figure above, it is also
indicated that there is a change in SML line because of the risk premium anticipated by the
potential investors (Mackaya and Haque 2016). For this reason, a change in SML can occur
in case there are changes within anticipated economic growth on a real time basis, inflation
rate and capital market conditions. For this reason, it can be stated that in an industry where
CAPM was applicable in all the assets that are an aspect of SML.

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Figure 2: CML Plot
(Source: Obrimah, Alabi and Ugo‐Harry 2015)
The Capital Market Line (CML) serves as line that indicates the return rate of an
effective investment portfolio after considering the risk levels related with the market
portfolio and the return from risk free rate. For this reason, this line identifies the risks
associated with a specific stock that is unsystematic risks and the ways in the functioning of
the overall market is impacted that is systematic risk. This explains that there is an
association among SML, CML and CAPM.
It is claimed by Rossi (2016) that CAPM is highly ineffective for the reasons it is not
able to deliver what it was developed to do. These reasechers have prepared several research
papers in an attempt to reveal a CAPM model alternative. It has observed that aa major
difficulty with CAPM is that it includes market portfolio theory greatly that is difficult to test
and is relied on numerous anticipations. The fact that CAPM is relied on several unrealistic
anticipations that must not necessarily accept too much from the model applicability. Certain
model advocates will also agree on the fact that it regularly anticipates the securities-based

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cost of capital in a fair manner and for this reason its recent regular use in several institutions
and for this reason its unrealistic anticipations must not matter. A three-factor model
developed by Tsuji (2017) through employing three major variables as different from the one
implemented in CAPM are used in explaining the stock returns. Their model also explained
that nit just beta serves as aa variable in anticipating a stock’s anticipated return, the book-to-
market ratio and market capitalization were also important in anticipating stock returns. It
was also revealed by these reasechers that small cap stocks tend to attain an increased book-
to-market ratio (value stocks) that have increased returns in comparison to the ones with
decreased book-to-market ratios or growth stocks. Incorporating these variables facilitate in
adjusting the tend of outperformance. This also concluded that beta was considered being less
vital in anticipating stock returns in comparison to other two variables.
According to the views presented by Zabarankin, Pavlikov and Uryasev (2014) it is
revealed that addition of two variables within the original CAPM computation is possible in
order to reveal that their computation was capable in justifying 90% of diversified portfolio
returns. On the other hand, CAPM was just capable to identify 70% of the returns. The
arguments of these reasechers are deemed effective and resulted in further debate from the
time their research was published. It was also elaborated by Zabarankin, Pavlikov and
Uryasev (2014) that evidence on CAPM is also relied on the data impacted by basis of
survivorship on COMPUSTAT. These reasechers also argued that they recognised no
increased returns with any of the identified three factors. However, the CAPM might appear
to be ineffective but still it is observed to be a renowned technique of anticipating the returns.
It is evidenced that “The theory and corporate finance practice: evidence from the field”
article elaborated that CAPM is a widely used technique that is used in percentage of 77.49%
within the industries. It was also revealed that CAPM or implementation of this model was

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employed by 85% of the companies those follow “best-practice” (Berk and Van Binsbergen
2016).
Tsuji (2017) revealed that CAPM model implication has numerous critics in the
industry that indicates a positive attitude towards CAPM that was deemed as a new model.
The major concern detected by the “The Harvard Business Review” that CAPM have
numerous critics and major concern was considered regarding the beta values that is subject
to variations over time for the reason that organization’s capital structure change even
through beta values are computed from the historical data. Moreover, several anticipations
like the anticipated turn on the market that are subject to error. Conversely, it was also
indicated that the CAPM model is employed in alignment with several other financial models
in anticipating the equity cost that is considered as “Weighted Average Cost of Capital
(WACC)” along with “Dividend Growth Model” that admits that CAPM is not that better in
comparison to financial model for anticipating equity cost.
Conclusion:
The objective of the essay is to analyse the recent developments in Capital Asset
Pricing Model (CAPM) to serve as an important tool and to explain a detailed development
within the area. It is gathered from the essay that most of the criticism related with the
original CAPM exist in the basic anticipations. Several critiques have also argued that there
are several assumptions and numerous assumptions among them are observed to be highly
presumptuous. Moreover, the researchers have also considered that for maintaining aa
genuinely diversified portfolio it can also consider all the investments in all the assets in all
the industries internationally. The essay also clarified that it is virtually impossible to attain a
real market portfolio along with the past and current empirical model testing is inappropriate.
These reasechers also argued that the CAPM can be considered identical to testing of an

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asset’s mean variance effectiveness. It has also been gathered that managers might be native
to employ the CAPM on their own and along with that there are numerous extensions of the
model that must be considered for use along with CAPM along with other traditional
techniques.
References:
Aggarwal, R., 2017. The Fama-French Three Factor Model and the Capital Asset Pricing
Model: Evidence from the Indian Stock Market. Indian Journal of Research in Capital
Markets, 4(2), pp.36-47.
Akpo, E.S., Hassan, S. and Esuike, B.U., 2015. Reconciling the arbitrage pricing theory
(APT) and the capital asset pricing model (CAPM) institutional and theoretical
framework. International Journal of Development and Economic Sustainability, 3(6), pp.17-
23.
Baker, M. and Wurgler, J., 2015. Do strict capital requirements raise the cost of capital? Bank
regulation, capital structure, and the low-risk anomaly. American Economic Review, 105(5),
pp.315-20.
Barberis, N., Greenwood, R., Jin, L. and Shleifer, A., 2015. X-CAPM: An extrapolative
capital asset pricing model. Journal of financial economics, 115(1), pp.1-24.
Barillas, F. and Shanken, J., 2018. Comparing asset pricing models. The Journal of
Finance, 73(2), pp.715-754.
Berk, J.B. and Van Binsbergen, J.H., 2016. Assessing asset pricing models using revealed
preference. Journal of Financial Economics, 119(1), pp.1-23.
Fama, E.F., 2014. Two pillars of asset pricing. American Economic Review, 104(6), pp.1467-
1485.

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Jarrow, R., 2018. An equilibrium capital asset pricing model in markets with price jumps and
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Kristoufek, L. and Ferreira, P., 2018. Capital asset pricing model in Portugal: Evidence from
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Mackaya, W. and Haque, T., 2016. A study of industry cost of equity in Australia using the
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