Capital Asset Pricing Model: Recent Developments and Criticisms

Running head: STRATEGIC FINANCE
Strategic Finance
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1STRATEGIC FINANCE
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.

2STRATEGIC FINANCE
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