Question

How successful has been the CAPM in explaining return on risky assets and What are the known issues Also Is beta stable?

Answer 1

Capital Asset Pricing model (CAPM)

The CAPM is frequently used to estimate the investor's required rate of return on a security or a portfolio of securities, given the perceived risk to the investment. The CAPM uses the security or portfolio's risk, the risk free rate of interest, and the expected return for the market portfolio to calculate the investors required rate of return for the security or portfolio of securities. A security's or portfolio's risk is expressed in it's BETA. Keep in mind the investors required rate of return is the minimum return investors will accept for an investment, it is the minimum rate of return that an investment must provide or must be expected to provide in order to justify making the investment. The investors required rate of return depends on the level of risk in the investment because investors will require a higher rate of return for a riskier investment.

Beta is a measurement of a security's or portfolio's Systematic risk. it is the risk that all investment are subject to, it is caused by factors that affect all investment assets such as inflation, macroeconomic instability, major political upheavals and wars. Systematic risk cannot be diversified away and so it remains even in a fully diversified portfolio. Beta is a measure of a stock's historical volatility compared with volatility of the market as a whole.

• BETA = 1 : The beta for the market as a whole is 1. an individual security or a portfolio with a beta of 1 has the same systematic risk as the market as a whole.the return of the security or portfolio has historically been the same as the return to the market portfolio.
• BETA > 1 : A beta greater than 1 means that the individual security or portfolio has historically been more volatile (riskier) than the market as a whole.
• BETA >0<1 : A beta between 0 and 1 means that the individual security or portfolio of securities has been less volatile ( Less risky) than the market as a whole.
• BETA = 0 : A risk free security has a beta of zero. However, having a beta of zero does not mean that security or portfolio of security is risk free. A beta of zero may mean only that historically there has been no correlation whatsoever between that security or portfolio's return and the return of the market.
• BETA <0 : A negative beta means the security or portfolio of securities has historically moved counter to the market. that is when returns to the market increased the return to the security or portfolio have decreased and vice versa.

CAPM formula: R=RF+ β(RM− RF)

R= Required rate of return

RF= Risk free rate

β = BETA

RM = Expected rate of return for the market portfolio