Markowitz's Capital Asset Pricing Model

Objective:

This essay is the result of an attempt to find out the Markowitz theory’s (put forth by him in 1952) practical relevance to todays world and its applications in industries.

Capital Asset Pricing Model:

Capital Asset Pricing Model (CAPM) provides theories of how the market prices of assets, securities or firm are determined. These theories provide frameworks that finance mangers use to maximize owners wealth. The model simplifies the complexity of the real world, assuming a linear relationship between investors’ required rate of return on the security and its beta. With CAPM one can develop security market line (SML). This model offers a methodology for quantifying risk and translating that risk into estimates of expected return

But it is widely used in many industries. It has been proved useful by the industries in determining the SML.

Studies show that relationship between past returns and beta is linear and positively sloped. High risk equals high return, low risk equals low return. The risk/return relationship is linear. The empirical SML is less steeply sloped than the theoretical SML. It means securities with low-beta perform better than CAPM’s expectations. Stocks with high-beta could earn less than expected.

Because of the questionable assumptions discussed above the CPAM model cannot precisely estimate the cost of equity capital. But this model can certainly indicate the way returns are determined in financial markets. Given that no other model can better predict the returns, and that the CPAM is simplified and elegant approach to ascertain the economic value of an asset, the CAPM is the model that has to be relied

Kushankur Dey and Debasish Maitra, “Portfolio Selection Revisited: Evidence from the Indian Stock Market”, IUP Journal of Applied Finance 18.3 (Jul 2012): 31-47.

2. http://www.nseindia.com/products/, Products, 31-07-2015

3. David W. Mullins, Jr, Jan 1982, “Does the Capital Asset Pricing Model Work?” https://hbr.org/1982/01/does-the-capital-asset-pricing-model-work

4. Philip Brown,Terry Walter, “The CAPM: Theoretical Validity, Empirical Intractability and Practical Applications”, Abacus Special Issue: The Capital Asset Pricing Model Volume 49, Issue Supplement S1, pages 44–50, January 2013

5. Shannon P. Pratt and Roger J Grabowski, “Cost of Capital Applications and Examples” New Jersey:Wiley & Sons, Inc, 2008

6. Samuel C Weaver and J Fred Weston, “Strategic Financial Management” Mason: Thomson higher Education, 2008

Appendix:

Beta and Cost of capital is calculated for CNX NIFTY HIGH BETA INDEX stock Axis bank just to illustrate the use of CAPM. This is not accurate as it considers only one month data.

Beta (Linest formula from SML)=0.0044

Rf = 7%

Cost of capital= Rf + Beta * Risk Premium = .07+.0044*(.014)