Capital Asset Pricing Model: Usefulness, Assumptions, and Limitations

Capital Asset Pricing Model
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Introduction
The Capital Asset Pricing Model (CAPM) is regarded as the best model in finance for
facilitating investment decisions by depicting a relation between the risks and returns of a
security. It however incorporates the use of various assumptions of a perfect capital market as
per which a linear relation is present between the expected returns and the market beta and does
not take into account other factors are necessary for explaining the expected returns from a
security. It has been regarded as a credible and reliable model for pricing of assets and foresting
the performance of an asset in the present dynamic business environment. It is theoretical model
used for determining the required rate of return of an asset on the basis of condition that an asset
is added into a well-diversified portfolio. As such, it is based on the condition that an asset
should be independent added into a diversified portfolio. CAPM is regarded as one of the best
asset pricing model but there have been other alternative models as well that have been
developed in the context of determining the price of an asset. These alternative models include
three-factor and five-factor model that have been proposed by Eugene Fama and Kenneth French
(Fama & French). In this context, this essay has been developed for presenting a discussion
regarding the usefulness, benefits and limitations of CAPM model in finance and its applicability
for determining the rate of return of an asset (Galariotis & Giouvria, 2015). The various
assumptions and estimates that the model has incorporated for determination of rate of return of
an asset has been discussed in detail within the essay. It also provides discussion about the
methods that can be used for eliminating the use of CAPM and also significant problems that
have been faced in its application.
Critical discussion on Capital Assets Pricing Model on the basis of its usefulness and
underlying assumptions
Concept of Capital asset pricing model
This model finds extensive use in pricing of assets by providing an analysis of the risk
undertaken by an investor and the expected returns to be achieved on the basis of risks
undertaken by them. The model has found extensive use in the field of finance as it is considered
to be the most reliable model that is used for determining an asset price by depicting a relation
between its associated risk and the returns. The CAPM model is being used extensively for
depicting the relation between expected rate of return on an investment and its associated
systematic risk (Fama and French, 2014). The formula that has been provided by the
model for determining the rate of return on an asset can be depicted as follows:
Ri = Rf + β (Rm – Rf)
The different components of the above stated formula:
where ‘Ri’ depicts required return on investment
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‘Rf’ is the risk free rate of return. The factor is not held constant and fluctuates in accordance
with the systematic risk in reference to the rest of the market
‘β’ is systematic risk or beta factor that depicts the risk in relation to the entire market
segment and is non-diversifiable as it is inherent within the overall market
‘Rm – Rf’ represents the equity risk premium that can be regarded as the additional risk for
investing within the capital market in addition with the associated premium return (Galariotis
& Giouvria, 2015).
Security Market Line
The graphical depiction of the CAPM model has been illustrated with the use of Security
Market Line (SML). The x-axis of the SML graph denotes the beta and y-axis has described the
expected returns on the stocks against the beta factor. The intercept of the graph is the risk free
rate and the slope depicts the market premium. The risk and return associated within individual
securities are plotted on the SML graph. An individual stock if it is plotted above the SML then
it represents that it is undervalued because investors are expecting larger returns for the same
amount of risk. However, the presence of a security below the SML represents that it is
overvalued and the investors would accept a lower return for the same amount of risk (Ang,
Hodrick, Xing & Zhang, 2006). The graphical representation of SML line is depicted
as follows:
(Source: https://valuationacademy.com/capm-capital-asset-pricing-model-security-market-line-
sml/)
Theory capital asset pricing model (CAPM) with its underlying assumptions
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