Capital Asset Gricing Model

Capital asset pricing model (CAPM) is an asset pricing theory is certain that the financial assets will be priced to generate rate of return which reimburse investors. A systematic risk that is calculated by covariance of the assets return with the market portfolio is called Beta (β). And if the added asset is an already part of the well-diversified portfolio, that asset is considered as a non-diversified risk which can be named as systematic risk or even as market risk.

Based on (efinance management, n.d.), the risk includes the factors not only applies to a systematic risks since it is inevitable by diversifying the investments but it will affect the whole market as well. This risk includes factors affect overall market such as changes in

The calculation for cost of equity is better compared to the dividend growth model (DGM) as it only take into account of a firm’s level systematic risk that is related to the stock market. Also, in weighted average cost (WACC) it provides a higher discount rates for use in investment appraisal. According to (Investopedia, n.d.) Weighted average cost of capital (WACC) will consistently weight each category when calculating the firm’s cost of capital. All sources of capital, and that includes stock, bonds and any other long term debts are included to calculate WACC. A firm’s WACC increases when both beta and rate of returns on equity increase.

However, there are a few limitations of CAPM. Such as impractical expectations, difficult to validity and also, beta do not remain stable overtime. Based from (Limitations of Capital Asset Pricing Model, 2009), CAPM depends on a number of expectations that are different from the actual situation. In example is, it is hard to find a risk free security. A temporary extremely liquefied government security is considered as free from risk security. Besides that, the hypothesis of the fairness of loaning and borrowing charges also

Mainly, the expectations may not be very serious for its concrete rationality. To find the risk of a security, there must be a connection between the expected returns and beta and the beta must be measurable. The empirical results have given mix results. There is a test that shows that there was a positive connection between expected returns and betas. However, it was not as convincing as predicted by CAPM. And in some analyses, it shows that there is no connection between returns and betas.

Thirdly, betas do not remain stable overtime. Beta is used to determine the upcoming risk. However, investors do not go beyond data to reckon beta. But, they only retain historical data of the market portfolio and share prices. The investors only uses past beta to determine future risk only if it is steady overtime. Thus, it is concluded that past betas cannot be used to predict future risk securities.

Therefore, CAPM is a useful yet not a perfect theory in practical implications as it make us understand the connection between risk and return even though there is a limitations for it. It provides a rational and assessable approach for reckoning risk. Besides that, it provides a usable measure of risk that helps investors to foresee what returns will occur upon putting their money at risk. However, the only issue is that the risk of an asset is not obtained only by