Question

(Asset pricing) ”The CAPM is a good measure of risk and thus a good explanation of the fact that some assets (stocks, portfolios, strategies or mutual funds) earn higher average returns than others.” Comment.

Answer 1

CAPM measures the expected return on an asset in relation to the prevailing risk free rate of return i.e. fixed interest payment bonds, treasury bills among others. Also it takes in to consideration the beta of the asset i.e. the volatility of the returns and the risk premium. CAPM is a useful measure of expected return on the asset if the investor is willing to take certain risk for the premium that will be gained over the risk free asset. It usually measures the excess returns for the risk take. Although CAPM provides a good measure of risk and returns, it should not be considered in isolation for measurement of risk and assessment of returns for stocks, portfolios. CAPM does not take in to consideration the best or worst case scenario and has fixed inputs of risk free return, beta and premium. It does not consider any standard deviations and has too many assumptions which may not hold good in all scenarios.