Question

IS Capital Assets Pricing Model (CAPM) is just a Myth? Or it has an empirical foundation? Justify with logical reasoning’s

Answer 1

Capital asset pricing model is certainly not a myth. Its foundation lies in the fact that a significant number of portfolio managers use the CAPM model to estimate the cost of equity however its some of the assumptions, whether its is valid in the real world or not can be questioned. The CAPM model uses the beta as a measure of risk. According to the CAPM model the required return on an equity stock consist of risk-free rate plus equity risk premium on that stock. The equity risk premium consists of beta multiplied by the market risk premium. The market risk premium is return from market portfolio minus the return from the risk-free asset. The CAPM model assumes that the risk of a security consists of systematic risk and non-systematic risk. The non-systematic risk of a security can be diversified away by investing in securities with negative correlation. The beta here is the measure of systematic risk and it measure risk in relative to the market so to at certain extent CAPM model is reliable however the assumption that non-systematic risk is always diversified away is something that does not always hold in the real world because all investors do not diversify their portfolio. The major advantage of using CAPM is that the variables can be easily obtained in the calculation and can be relied upon for its accuracy.