Question

Critically analyze the merits and demerits of the Capital Asset Pricing Model (CAPM) and discuss its value in practice.

Answer 1

Capital asset Pricing Model (CAPM) is the mathematical model to ascertain the expected return of risky assets, typically stock. This model is based on the relationship between the return on market portfolio (risky asset) and that on the risk free assets like Treasury instruments.

As per CAPM,

R_e= R_f + β(R_m-R_f)

Where R_e= expected return on the stock, R_f= Rate of return on risk free asset, β =beta coefficient, R_m= Market return.

Beta coefficient is the measure of volatility of the return of a stock, vis-à-vis the market return. This ratio indicates the degree of change in return consequent to a given change in the market return (the return on bench mark index). A beta higher than 1 indicates that the stock is more volatile than the market. As a result, reaction in price of the stock to an unsystematic risk event will be greater than that of the market in general. Reverse is the case of beta less than 1.

CAPM gives indication of likely short-term movements. However, this method, being purely based on past data, need not predict with the required degree of accuracy in the long run. Hence, investors need to consider other factors also. Another limitation is that Beta as a measure of risk is not accurate assumption since volatility measured could be in either direction. Also, this model assumes that risk free rate will remain unchanged over the discounting period which need not be correct. Investors should also realize that comparison, being with a large index as the market, might not reflect the real position with regard to the individual stock.

CAPM is widely used for estimating possible returns on stock as it is convenient and easy to use/ understand. Since cost of equity is measured in terms of the investor’s expectation of return from equity, CAPM is used to assess the cost of equity capital in capital budgeting.