In this essay I will try to present CAPM framework and explain the idea behind it. In 1959 Harry Markowitz published his portfolio theory to introduce notions of systematic and specific risk. William Sharpe (1964) and John Lintner (1965) developed The Capital Asset Pricing Model widely known as CAPM which was an extension of Markowitz's portfolio theory. CAPM defines the relationship between risk and return for individual securities. For developing the idea of CAPM Sharpe was awarded in 1990 Nobel Prize in Economics. 'Four decades later, the CAPM is still widely used in applications, such as estimating the cost of capitals for firms and evaluating the performance of managed portfolios.' (Fama and French (2004))
'The basic idea behind the capital pricing model is that investors expect a reward for both waiting and worrying. The greater the worry, the greater the expected return.' (Barley, Myers and Marcus (2010)) This means that if we invest in risk-free bonds we will receive the rate of interest only and this will be reward for 'waiting'. On the other we can invest into risky stocks and expect extra return for the fact that we are 'worrying'. CAPM shows the relationship between risk and expected return. It states that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat our required return then we should not invest. The CAPM can be expressed algebraically as:
E(R) = Rf +[E(Rm) - E(Rf)]
E(R) is the expected return on an asset or portfolio not related with the market
Rf is the risk free rate
Rm is the expexted market return
equals to Cov(R, Rm) /2(Rm). Beta measures the volatility of the security, relative to the asset class
CAPM divides portfolio's risk into systematic and specific risk. The first one is the risk of owning the market portfolio. Every single individual asset is more or less affected due to the market moves. Hence every asset participates in such general market moves, it carries the systematic risk. Specific risk on the other hand is the risk which is unique to an individual asset. In other words it shows the component of an asset's return which is not related to the general market moves. According to CAPM assumption, the marketplace pays off investors for taking systematic risk but not if they take specific risk. This is due to the fact that specific risk can be diversified away. In every portfolio each and every asset carries specific risk with it. However if the investor is diversifying the market portfolio the net exposure is just the systematic risk. Thus CAPM can show us the expected return of any asset or market portfolio which is based on only three elements assets' risk represented by beta, the risk premium of the market, and the risk free rate. That is why at the first look CAPM model looks like an amazing financial tool because it is simple, hence we need only three different elements, and it can give us an answer to questions about return on our investments. However we have to bear in mind that CAPM is an economic model and like any other model it is not a reflection of the real world we live in. CAPM is based on different assumption and because of them we can have a working model in real complex financial world. The first of the few assumptions tells us that there no transaction costs on the market. This is not true in the real world as the transaction costs occur and they have affect on the investment decisions, because investor can not just shift assets from one portfolio to another one without paying the transaction costs. The second assumption regards situation where in CAPM investor can buy as many assets as he wishes. Where in real world this is impossible hence almost every asset has a unit price. The third assumption is excluding personal income tax from the CAPM model which has to be paid in the real world and has got affect on the investment. The fourth assumption presents ulimited lending and borrowing at risk free rate in the CAPM. This means that investor can borrow and lend quantities at rate of the risk less security. In the reality this can not happen. Next assumption states that investors make their decision based only on standard deviation and expected value. However in reality we can observe certain tastes and trend on the market. So we know that investors are not only driven by the capital gains. Another assumption for CAPM states that all the assets can be bought on the market that includes human capital. But in the reality we know that it is impossible to put all the assets that exist in the world on the market. CAPM also presents homogeneity of expectations in regard to all the investors. This means that all of the investors have identical expectations from their investments. However in the real world all of the investors are heterogenic when we talk about expectations. Another assumption is the historic data. CAPM model tries to answer a question about future returns however it is solely based on information from the past. For instance Betas are calculated by using data from the past periods hence they not necessarily have to be appropriate in showing the variability or risk of future returns. This is why the results shown by the CAPM should be only viewed as approximated predictions. Some of the assumptions are impossible to imply in the real financial world. Thus we can say that the CAPM is very limited by its assumptions. But we can not reject a CAPM only because it has got simplifying assumptions. We would have to rather check if it can be use successfully and effectively to predict return from investment.
Because of the many limitations in the real world CAPM has been closely checked by many researchers. In some cases they have found evidence supporting the model, or at least some of its aspects. But there were also some who tried to prove that there is no empirical evidence supporting CAPM model. The first criticism of the CAPM model was presented by Richard Roll in his paper from 1977. In his article he questioned the possibility of implementing the model in real life situation. The milestone in testing empirical evidence of validity of CAPM model came in 1992 from research done by Eugene Fama and Kenneth French. They have found a link between historical betas and stock returns while they were testing data from NYSE. They have fund out that size of the firm is significant for stock return with or without using beta. This was based on the research on data from 1963 to 1990 from NYSE. They have also presented a 3 factor model that is taking into account as firm size and book - to - market equity. Although there is some empirical evidence of limitations to the CAPM model some of the researchers argue that the test carried out are only valid to a certain samples and can not be related to the whole market.
In conclusion, the CAPM developed by Sharpe (1964) and Lintner (1965) is a very simple two factor model and despite its limitations it can be helpful at giving investors a look at the risk and return on the investment. Nevertheless it has been proved that CAPM is failing when it comes down to empirical evidences as they are cancelling most of the assumptions presented by CAPM. This empirical fiasco of the CAPM could be explained by using bad proxies for the market portfolio during the researches. That is why CAPM can be applied to give a view on analyzing risk and return however, it should not be use alone on the investment decision process, as it not very useful tool for approximating the expected returns.
