The CAPM is based on a set of assumptions that are used to create a simple alternative to the real world allowing it to be analysed more freely. The assumptions that it follows are that; investors want to maximise utility and are rational, thus eliminating unnecessary risk, investors can access information freely, investors can borrow and lend at a risk free rate, investors have broad portfolios in turn eliminating unsystematic risk, capital markets are perfectly competitive and investments occur over a single standardised holding period (Watson & Head, 2010). With these assumptions in place the CAPM can begin to be applied to two key variables: risk and return. CAPM explores the correlation between these two variables, and this analysis is known as the security market line.
The CAPM is based around multiple elements of risk as it needs to provide a complete overview as to how the market is performing and also how this performance affects securities within that market. It has already been established that it avoids looking at unsystematic risk, as this risk is void when looking at securities as it can be eradicated through portfolio diversification. Therefore the CAPM's emphasis lay largely on systematic risk and its beta. It uses systematic risk as this gives an insight into how the returns of a security will fluctuate in response to a change in the market.
Beta (β) is used in the CAPM in order to calculate how responsive a change in the returns of a security is relative to a change in the market or alternatively the stock exchange. It is measured as an index based on the market or stock exchange, which is set at a fixed level; 1, to be used as a comparison in order to determine the systematic risk generated by the security. This allows you to gauge how sensitive the returns associated to a security are given a change in systematic factors. The beta allows us to analyse the securities very simply and effectively, for example with the market fixed at 1, if a security has the beta of less than 1 it can be defined as a defensive security, alternatively if the beta is more than one it is known as an aggressive security.
The security market line looks at the linear correlation linking the required rate of return and systematic risk. The security market line attempts to quantify the necessary return of a security and in the process, to create a fair price for said security. This is achieved by comparing the risk and return of the market, the risk free rate of return and finally, the systematic risk of the selected security. The formula for the security market line is stated below:
Ri = Rf + βj(Rm - Rf)
Whereby; Ri is the rate of return received from security j which is predicted by the model, Rf determines the risk-free rate of return, βj is the beta coefficient of security j and finally Rm which measures the return of the market.
The CAPM has four main uses; to estimate the required returns on a company's stock, as a means to evaluate the risk involved with a company's project and finally it can be used to explain why the use of debt by firms can increase their risk and consequently increases the required rate of return needed by the stockholders and finally it can be used to calculate the benefits that a company or shareholder will gain through a merger (Schall & Haley, 1991).
The security market line is crucial in the process of using the CAPM to value shares and taking into account systematic risk (beta) and the required rate of return the linear correlation between the two is key to the CAPM. The security market line analyses each security separately and when each has been calculated and plotted on a graph. The security market line is linear with a positive correlation and therefore any share on the line is correctly priced, however if a share falls below the line it becomes over priced and if it is above, underpriced. This method of share valuation is applicable to the real world however shares will take longer to join the security market line and in the long run the relationship between systematic return and risk will weaken.
When the CAPM is used as a means of investment appraisal it acts as an alternative to the traditional calculation of a company's weighted cost of capital (WACC). It is dissimilar to WACC however as it allows companies to target specific projects and measure the required rate of return that is associated with said project. The CAPM in these circumstances allow companies and investors to make better investment decisions when undertaking projects that are unfamiliar to the business and produce different risk characteristics. It achieves this by looking at the risks associated with the project which gives it a more reliable figure in comparison to WACC which disregards project risk.
When a company or two shareholder groups decide that they are going to merge, the CAPM can be used to identify how beneficial the takeover will be. It does this by measuring expected returns on the shares held by both company before and after the bid has taken place. These figures are then compared to the actual returns in order to identify any anomalies that have occurred over the merger process allowing the company's to analyse whether gains outweigh loss. This is supported by (Franks, Harris, & Mayer, 1988) and (Firth, 1980) whereby they discovered that in the UK acquiring companies rarely had abnormal gain through the takeover process, illustrating how the CAPM offers a very substantial means of comparison.
CAPM's uses however, have been subject to scrutiny and debate about how the model can be applied to real world situations due to its various assumptions. However (Sharpe, 1964) stated that "the proper test of a theory is not the realism of its assumptions but the acceptability of its implications" and therefore, whilst the assumptions may not directly extrapolate into the real world, the ideas brought forth from the theory can be applied to real scenarios. People have also argued that beta may be dead due to inaccuracies that appear when beta is used in the real world.
When applied to the real world the CAPM's assumptions begin to highlight how the models assumptions may contrast with the real world, thus questioning the use for the CAPM. Firstly there is an assumption that people are risk adverse and can avoid unsystematic risk by being able to fully diversify. However when this is applied to the real world, investors may not be defined being risk adverse or a risk taker, as they may hold preferences to different securities and will select a range of securities with varying risks. Secondly, the investors may not be able to expand their portfolios to a level in which unsystematic risk its eliminated, thus questioning the integrity by which the CAPM has real life applications.
There are three different attitudes that an investor can take towards risk; risk-loving, risk-neutral and risk-averse, and these can complicate the CAPM as each investor will be different and therefore the beta may not affect how an investor chooses their securities. A risk-loving investor prefers a high level of risk if there is a promise for a high level of expected return, on the other hand a risk-averse investor will opt for a low risk, low return investment and finally the risk-neutral will be indifferent to any proposed level of risk. Now, it is expected that the investors are utility maximisers and will therefore always be attempting to increase their utility by shifting to a new indifference curve, which allows them to increase their utility. Linking this back into investors attitudes to risk, each investor will each be trying to maximise utility, however each will have a unique indifference curve that establishes their preferences with regards to the expected rate of return and the risk associated to their investment. So when the beta is calculated for the CAPM, and there is data that determines whether the security is aggressive or defensive, this may not be relevant as to what the investors will do as each will have different preferences and attitudes to how they can maximise their utility.
Another factor that can be addressed is that the CAPM is based on previous data in order to predict what will happen in the future. This creates a problem when addressing the real life economies as they are in a constant state of fluctuation, and therefore the figures that the CAPM is based on may not be an accurate assumption of what the economy will do in future. For example the current economy has fallen into the second largest recession since 1930 all following an economy that had been consistently growing for the past 15 years (BBC, 2011). Therefore the CAPM would predict that the beta is more than one and investors are buying aggressive shares, however when the economic downturn comes about the beta will be inaccurate and the figures in which the CAPM was calculated become imprecise. In addition to this, market failures will also be evident in the real market a perfectly competitive market is impossible to achieve in real life and the assumptions that this entails create further impracticalities for the CAPM. However, this may be less relevant now than in 1964 due to the much greater level of information available to even individual investors over the internet, so market conditions are becoming closer to perfect in comparison to 1964.
(Fama & French, 1996) Stated that "average-return anomalies of the CAPM are serious enough to infer that the model is not a useful approximation". They supported this claim by observations that the market proxies will ignore average return anomalies, leaving beta unreflective of expected return. Sharpe defended in an interview saying that CAPM is not dead due to the principle that the risk associated with the market will affect the performance of the security both positively or negatively. So with regards to whether beta is dead? Sharpe stated that the accuracy of the beta may be compromised due to the market imperfections, however the beta will remain fixed to the security. (Sharpe W. , 1998)
Therefore we can conclude that the CAPM is a useful model as it can be used for many functions from the valuation of shares to investment appraisal, however when determining its uses and applying it to the real world its fundamental assumptions hinder its ability to explain actual markets. However as defended by Sharpe himself, the assumptions make the model accurate to be used as an example, but even with the assumptions in place the theories, although maybe not directly, can all be applied to real world situations and markets.
