Question

Examine and critically discuss the following statement, with reference to relevant theory and empirical evidence: “Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return and there should be no mispricing of stocks in the financial market.”

Answer 1

The CAPM Model is the model used to describe the relationship between the systematic risk of the security and the expected return. According to this model

Required return = Risk free return + Beta*(Market Return - Risk free return)

Risk free return is the return the investor gets when there is no risk in the security. Its variability (or beta = 0). FOr example Treasury Bills.

Market Return is thereturn that can be obtained in a bundle of security perfectly replicating the market index say S&P.

So Market Return - Risk free return = Market Risk premiuim which indicates the additional return an investor can get by investing in the market and taking risk.  

Beta is the measure of the voltatlity (risk) of the stock vis a vis the market portfolio. If the stock is considered more risky, then its beta will be high (more than one)

However the CAPM model is also criticised on the basis of assumptions it took. In the real world we can see that the assumptions of CAPM are not holding up, and therefore all the securities are not fairly priced. the criticism are as follows:

1. Identification of Risk Free security, There is no security such as risk free, Even if we take treasury bills it is at best an approximation of risk free security not an actual risk free.

2. Beta is based on the historical data not on the future estimation. In todays dynamic world, the estimation on the basis of historical data cant be accurate.

3. Investors are assumed to be active investor having all infomrtaion and rapidy taking action on the basis of change in economic factors. However most of the time investors are passive investors not active.

4. The taxes are assumed to be nil, which is not the case in rela world.

Thus to say “Under the CAPM, the required rate of return on a firm's common stock is determined only by the firm's market risk. If its market risk is known, and if that risk is expected to remain constant, then analysts have all the information they need to calculate the firm's required rate of return and there should be no mispricing of stocks in the financial market.” is incorrect.