Analysis Of The Capital Asset Pricing Model

1. Introduction

The Capital Asset Pricing Model (CAPM) is an asset pricing model that was first introduced by William Sharpe (1964) and John Lintner (1965). Professor William F.Sharpe was even been awarded with Nobel Prize in Economics since he came out with this model and theory (Brealey, Myers & Marcus, 2015). Despite more than four decades has passed, CAPM is still very popular as this model helps to estimate the cost of capital for companies and individual and it helps to assess the performance of the portfolio (Fama & French, 2004). However, empirical evidence has proved that it is not very realistic as it is based on very strong assumptions and there are some critiques to this model. This essay will discuss the uses of Sharpe-Lintner

This model assumes that the company or individual holds a diversified amount of investment to create a portfolio so that they can reduce the risk. Although it is possible for firms to invest in portfolio investment, not many individuals have the financial capability to invest in many investments.

2.2 Second Assumptions – Markets are competitive and

Critiques to CAPM model

Two of the most renown critiques on this model is made by Eugene Fama and Kenneth French, who later have developed their own model to replace CAPM. Roll also criticize the flaws of the model.

3.1 A single factor is insufficient to estimate the returns of investment

CAPM model only uses one variable which is Beta to explain the returns of a stock with the returns of the market. Beta is used to measure the risk or sensitivity of a project and CAPM model shows that the relation between required expected return and beta is linear (Jagannathan & Wang, 1996). However, according to Eugene Fama and Kenneth French, the correlation between market beta and U.S. common stocks. It is insufficient to rely on one single factor to estimate the expected returns of the investment as there will be other factors affecting the price of stock in the real world (F.Fama & French, 1993).

3.2 CAPM is not testable

Richard Roll claimed that CAPM is similar to testing the mean variance efficiency of the asset. He claims that CAPM cannot be tested unless the precise composition of the market portfolio is known and all the assets can be marketed which is impossible for the real world. Hence, he added that using proxy for the market portfolio is dangerous as the proxies might be inefficient despite the proxies in the model might present to be efficient (Roll,