Strategic Finance: CAPM Usefulness and Developments Analysis

This essay critically evaluates the Capital Asset Pricing Model (CAPM), addressing its usefulness and widespread adoption in the finance industry despite its strong assumptions. It discusses the model's ability to depict risk and return, its reliance on beta for sensitivity analysis, and its role in determining the cost of equity. The essay also examines criticisms of CAPM, including Roll's critique of empirical testing and Fama and French's concerns about unrealistic assumptions. It further explores the assumptions underlying the CAPM, such as risk-free rate variance, homogeneous expectations, and the absence of transaction costs and inflation, while considering relaxations related to differential borrowing and lending rates and transaction costs. The essay concludes by addressing critiques of the CAPM, including issues with unrestricted risk-free borrowing and lending, the relation between market beta and expected return, and the limitations of market betas in detecting changes in expected returns.

Running head: STRATEGIC FINANCE
Strategic Finance
Name of the Student:
Name of the University:
Authors Note:

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Table of Contents
‘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. Discuss in the light of recent
developments in the area.’..........................................................................................................2
Introduction:...............................................................................................................................2
Discussion:.................................................................................................................................2
Conclusion:................................................................................................................................9
References and Bibliography:..................................................................................................10

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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. Discuss in the light of
recent developments in the area.’
Introduction:
Capital Asset Pricing Model is considered to be only of the useful model, which
allows investors to detect risk and return from different stocks. However, the advantages and
disadvantage of Capital Asset pricing model is also for understanding the benefits, which can
be conducted by investors. Furthermore, the different usefulness of the Capital Asset pricing
model is disused, which directly allows the investors to select investments, which has higher
growth opportunity. Regardless of the assumptions used in Capital Asset pricing model the
output given from the equation allows investors to select stocks, which has future profits.
There is recent development in the area of Capital Asset pricing model strengthens the value
of output, which can improve financial performance of the portfolio. However, the
continuous use of Capital Asset Pricing Model is mainly conducted, due to its capability to
account for the systematic risk associated with a particular stock. On the other hand, the
model does not account for unsystematic risk, which is considered to be one of the major
flaws of Capital Asset Pricing Model. Hence, with further discussion adequate light on the
area can be portrayed.
Discussion:
Capital Asset pricing model has adequate credibility, where it is able to depict the
current return and risk for particular stock. Investors due to his popularity to account for
systematic risk rather than the unsystematic risk a particular stock relatively use CAPM
model. Moreover, the model actually uses beta to identify sensitivity of the stock and return

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that is to generate over the period, which are relatively helpful in depicting the investors cost
of equity. This determination of cost to equity relatively helps investors in making adequate
investment decision and creating a portfolio. Furthermore, Barberis et al. (2015) indicated
that with the help of the model security market line is relatively depicted for each particular
stock where the relationship between the risk and return are adequately analyzed. The works
of John Lintner, Jack Treynor, William Sharpe and Jan Mossin has mainly allowed us to
witness the CAPM model, which uses one factor in analyzing the expected return of the
stock. The model has allowed William Sharpe to attain the Nobel Prize in 1990 for the works
and contributions, which was made in CAPM. The achievements made after completing the
model relative allowed the contributor with undue criticism due to the presence of certain
limitations within the assumptions of the model. The criticisms mainly occur due to the
problems that were identified within the evaluation of CAPM model. There were many
extensions that were developed for supporting results of CAPM, which has relatively help in
depicting or more accurate expected returns of particular stock. However, Kuehn et al. (2017)
argued that the calculations that are conducted for the extension of CAPM relatively needs
extensive calculations and statistical analysis, which is far more complex than the underlying
model.
The main critic of Capital Asset pricing model was Richard Roll who directly charged
the founders of the model with empirical test, which where inefficient in detecting the
unobservable market Returns which, is used in the model. The critic also argued that the
CAPM formula is relatively similar to the mean variance efficiency testing method, where the
mean variance efficiency of a market is unobservable. The further criticism relatively came
from Fama and French who claimed that Capital Asset Pricing Model to be useless, as it did
not deliver the result for which it was developed. Fama and French also highlighted that the
Capital Asset pricing model relatively constitutes most of the market portfolio theory, which

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increases the challenge for the investor, as there are too many assumptions, that need to be
taken into consideration. Fama and French also highlight that the CAPM formula is relatively
based on unrealistic assumption, which reduces the credibility of the model in depicting the
accurate expected returns of a stock. However, the advocates of the Capital Asset pricing
model good relevantly indicate that with the presence of the formula investors are able to
understand the expected returns and the risk involved in investment in a particular stock. On
the contrary, Fama and French in 1993 introduced a three Factor Model, which was
considered an alternative for the Capital Asset pricing model.
Assumptions of the model:
There are specific assumptions that need to be fulfilled for detecting the results from
the Capital Asset pricing model. The CAPM directly extends the market portfolio model,
which was initiated by Markowitz, whose aim was to detect the level of risk and return
attributes that was used by investors while conducting investment decisions. Zabarankin,
Pavlikov and Uryasev (2014) mentioned that the assumption of the model is a relatively
based on risk, where it indicates that the rising result eventually increase the level of return
that will be generated from the investment. On the other hand, the reduced level of risk will
directly decline the level of metals that could be generated from an investment. CAPM
measure directly extended the mean variance model by analyzing and implementing different
levels of assumption. There are 7 specific assumptions that need to be conducted in Capital
Asset pricing model, which needs to be considered while calculating through the model. The
first assumption is relatively indicates the use of risk free rate variance and market returns to
determine the level of risk and return attributes of the investment. The second assumption
that is used in the model is that investors can borrow or lend risk free rate of return at any
given time (Tsuji 2017). The third assumption directly indicated that investors have
homogeneous expectation, which states that the future rates of the returns have same

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distribution. The fourth assumption made in the model is that investors use the same period
for investment. The fifth assumption indicates that investors are able to buy and sell the
portion of shares of security they hold. The sixth assumption that is taken into consideration
is there is no transaction cost of taxes for purchasing and selling the assets. The last
assumption is relatively identified, as there is no inflation rate change in interest rates that has
occurred during the investment. With the identified assumptions, investors are able to detect
the level of expected returns from investment (Mackaya and Haque 2016).
There is certain relaxation that needs to be implemented in CAPM formula for
deriving the results of the model. The relaxations are depicted as follows.
Differential borrowings and lending rates:
The differential borrowing and lending rates that is used in the Capital Asset pricing
theory relatively act as a relaxation of the assumption that is needed by the model. The
inequality of lending and borrowing rates that is used is relatively highlighted by different
researchers, which directly alter the relationship between risk and return of stock. The
inequality between the boring and lending rates will directly affect the market risk-return
trade off, which is used in the calculation of Capital Asset pricing model. Therefore, the
changes in the current lending and borrowing opportunities could not improve an investor’s
risk exposure in the capital market. The assumptions regarding the lending and borrowing
today relatively reduce the credibility of Capital Asset pricing model, as the lending rates are
relatively lower than borrowing rates. The assumption directly indicates that investors borrow
money and buy risk free government Bond for securing their investment. However, Squartini
et al. (2017) argued that the rates of the government relativity lower than the lending rates,
which restrict investors to borrow unlimited funds for investment. Consequently, it could be
understood that the history resume by the Capital Asset pricing model needs to be control by

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the investors, which might help in securing the level of returns that could be generated for an
investment.
Transaction costs:
The model also has a relaxation policy for the transaction cost, where it is assume that
the Capital Asset pricing model does not have any kind of transaction cost. This relatively
allows the investor to buy and sell securities without incurring the transaction expenses. The
Capital Asset pricing model that without the presence of transaction cost the investors can
adequately buy and sell the stock until it lines of with the risk and return conditions of the
model. However, the presence of transaction cost will affect the correction that is being made
by the model for the mispriced asset. Therefore, it is understood that the cost of buying and
selling the mispriced security can potentially offset the excess return that is indicated by the
Capital Asset pricing model. Hence, the presence of the transaction cost will not plot the
securities on the security market line, where it will be plotted close of the line. Thus, Berk
and Van Binsbergd (2016) argued that it could be understood that the presence of the
transaction cost will directly affect the extent of diversification, which can be made by the
investors. The CAPM model can eventually help in deriving the excess returns, which can be
generated from a particular investment, while the presence of transaction cost can hinder the
results derived from the model.
Critique of the CAPM:
Unrestricted Risk-Free Borrowing and Lending:
The major critic for the CAPM model was the unrestricted risk free rate borrowing
and lending rate, which was used for deriving the expected returns of a stock. The researches
directly indicated the problems that were within the derivation of risk free rate, which was
actually considered unrealistic. Therefore, Vu, Chai and Do (2015) indicated that adequate

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problems can be identified in deriving the unrestricted borrowing and lending rate that is
needed by the model.
Relation between Market Beta and Expected Return:
The relation between the market beta and the expected return that is calculated with
the help of CAPM model relatively considered unrelated. The arguments that have been
imposed by different resources and analyst literally indicate that the expected return is
unrelated to the market beta that is used in the model. The model directly reflects that the
overall change in expected returns from a particular portfolio is only derived from the
alteration in market beta and no other variables. This derivation directly indicates that the risk
factor involved in the evaluation process directly derives the level of return that a stock needs
to provide to investors. However, there are certain limitations to the assumptions that have
been made in the Capital Asset pricing model. According to Cai, Ren and Yang (2015), the
use of earnings for price ratio relatively allows the investor to identify the actual future
returns that can be generated by an organization, which is far accurate than the CAPM model.
Moreover, the further criticism indicates that book to market equity ratio provides an in-depth
knowledge regarding the current and future prices of a particular stock in comparison to the
Capital Asset pricing model. However, the current research that has been conducted on the
CAPM model directly indicates that the market betas are imperfect and insufficient to detect
the changes that are conducted on expected returns. Therefore, the use of earnings to price,
debt to equity and book to market ratios are considered one of the good determinants for the
expected returns.
Fama and French relatively discussed the limitations of the Capital Asset pricing
model, which indicated the use of unrealistic assumptions that were not able to comprehend
the expected returns of a stock. The duo directly indicated that the use of company size,
earnings ratio, debt to equity ratio, and book to market ratios can allow the investor to

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understand the risk and return attributes of a particular stock. However, Elbannan (2014)
criticizes that the calculation that has been proposed by Fama and French relatively indicates
the use of extensive research, which needs to be conducted for each stock.
Three Factor Model:
Fama and French mainly proposed the Three Factor Model, which is relatively, help
in detecting the accurate expected return of a particular stock (Fama and French 2017). The
model was relatively in developed in view of the limitations that were identified in the
Capital Asset pricing model. The Three Factor Model was able to determine and explain the
results of the portfolio that was being calculated for investment purposes. The Three Factor
Model relatively help the investors in detecting stocks with high book to market ratio, which
would eventually improve the level of investment that could be conducted in stocks. The
anticipation of the Three Factor Model relatively indicated that the systematic risk of a
particular stock could be identified with the help of book to market ratio, which is not
comprehended by the beta derived from the Capital Asset pricing model. Thus, the Three
Factor Model can be identified, as a bigger version for the CAPM model, which comprises of
firm size, value of the firm and market risk factor used in CAPM.
The criticism of the Capital Asset pricing model is relatively high, which is mainly
conducted by the searchers and analyst. However, the model is widely used by the investor
for identifying the expected returns of a particular stock. The inefficiency of the model has
not affected its popularity among the investors, which still in the current era use the method
for detecting the level of returns that can be generated from a stock. the new models that has
been proposed instead of the Capital Asset pricing model has high level of calculation that
need to be conducted by investors for deriving the expected return for particular stock. Tong,
Hu and Hu (2017) argued that the error actively limits the use of extended formulas to high-
level investor, who are able to detect the prize structure and valuation of a particular stock.

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Nevertheless, the different combination and methods that is used by the CAPM model has
allowed investors to use different formulas such as weighted average cost of capital and
dividend discount model for deriving the valuation of a particular stock.
Conclusion:
After evaluating above statement that is being mentioned about the Capital Asset
pricing model, it could be understood that the predictability of the method has allowed
investors to detect the cost of equity for their investment. Furthermore, the limitation that has
been highlighted by different researchers and economist has relatively indicated Problems are
relatively considered in assumption that was needed for the calculation. However the
limitations that has been paused does not indicate the problems of the model, as it is
considered to be one of the unique method for accounting the systematic risk of a particular
stock. Therefore, investors can utilize the Capital Asset pricing model for detecting the
accurate measures that can be taken for improving the current Portfolio created for
investment. Consequently, investors can use The Capital Asset pricing model and their
extensions for detecting the expected returns and affecting their investment capital. The
different types of alternative that has been proposed by researchers have extensive
calculations that need to be conducted for deriving the expected return of a particular
investment. Thus, investors can use the alternative method if they have adequate resources
such as statistical tools for calculating the expected returns of a particular stock.
Nevertheless, easy process of the Capital Asset pricing model has made the measure popular
among investors, which allow them to detect the systematic risk of the stock.

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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.
Cai, Z., Ren, Y. and Yang, B., 2015. A semiparametric conditional capital asset pricing
model. Journal of Banking & Finance, 61, pp.117-126.
Elbannan, M.A., 2014. The capital asset pricing model: an overview of the
theory. International Journal of Economics and Finance, 7(1), p.216.
Fama, E.F. and French, K.R., 2017. International tests of a five-factor asset pricing
model. Journal of financial Economics, 123(3), pp.441-463.
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Kim, K.H. and Kim, T., 2016. Capital asset pricing model: A time-varying volatility
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KUEHN, L.A., Simutin, M. and Wang, J.J., 2017. A labor capital asset pricing model. The
Journal of Finance, 72(5), pp.2131-2178.

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Lee, H.S., Cheng, F.F. and Chong, S.C., 2016. Markowitz portfolio theory and capital asset
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