How can Investors do to construct an efficient portfolio? The capital asset pricing model is a method for investors to evaluate risk and return from security. Capital asset pricing model was developed by Financial experts Treynor(1961), W. Sharpe(1964), J. Lintner(1965) in 1960. The model is based on modern portfolio theory which uses diversified investment to disperse risks. The reason why capital asset pricing model is still popular nowadays is that it provides effective and intuitive predictions for investors to weigh expect returns and predicable risks. As luck would have it, according to the research from Eugene F. Fama and Kenneth R. French shown that the capital asset pricing model is not perfection in practical usage because the model is based on some assumptions. This essay will analyze those factors in following paragraph.
In finance, we use capital asset pricing model to evaluate investment risk such as stocks bonds and other securities of an asset. Investors can determine the price of capital assets precisely through capital asset pricing model. Unstable expect return of an asset is influenced by risk factors, while those factors can be divided into two categories; systematic risk and non-systematic risk. Non-systematic risk can be dispersed by diversified investment like stocks to achieve efficient portfolio. For an investor who holds a diversified and efficient portfolio, he only needs to pay close attention to the most remarkable risk like consumer price index and interest rate from security market and control the systematic risk from the security market. The essay is going to critically analyse the advantages and disadvantages of capital asset pricing model and compared to other finance models.
The capital asset pricing model is based on a coefficient Beta, Beta coefficient is a measure of an asset to the systemic risks. It’s the main parameter of capital asset pricing model used to measure a security or a portfolio related to volatility of aggregate market and securities systematic risk assessment tool. The Beta coefficient is defined as. In which Ri is return on the capital asset and Rm is the return of the market. The formula for capital asset pricing model is E(Ri)=Rf+(E(Rm)-Rf), where Rf is defined as risk-free rate (i.e., the expected return on the risk free asset).
As the essay mentioned in the first paragraph. Capital asset pricing model is criticized as unpractical model due to the model is based on several assumptions, for those assumptions the model is limited in practical usage. The assumptions are shown on following paragraph.
1. Investors hold diversified portfolios
When all the non-systematic risk is removed or ignored, investors will only gain returns for the systematic risk of their portfolios. The capital asset pricing model is not suitable for single portfolio holders.
2. Single-period horizon
A normal holding period of a security is assigned by capital asset pricing model. The reason for this is to make comparison between different securities. For instance, a return over than three month cannot be compared to a return over than six month.
3. Investors have the some risk-free rate of return in borrowing and lending.
The assumption is comes from portfolio theory which capital asset pricing model was developed and offer a minimum requirement of return for investors. The risk-free rate of return follows the intersection of the security market line. The security market line is representing to the capital asset pricing model formula.
4. Perfect capital market
This assumption indicates all the securities have correct value and returns will reveal on the security market line. A perfect capital market is composed without taxes or transaction costs. For all investors all want to avoid risks and maximise their returns.
Although the assumptions which assumed by capital asset pricing model accept it concentrate on the relationship between return and systematic risk. Unfortunately the realistic world cannot be constituted by assumptions, especially investment decisions are decided by individuals and companies. For instance, any capital markets in the world are obviously not that perfect, even though it can be challenged that a well-organized stock market practically reveal a high level of efficiency, there still have a chance for stock market securities to be priced in an inaccuracy. Consequently, in this situation, their returns will not be illustrated on to the security market line. The assumption of single-period horizon indicates differences between real situation and theory, for investors usually holding securities for several years but returns on securities are usually pricing per annum. Another remarkable problem is that, in practical way, it is impossible for investors to barrow at risk-free rate, because individual investors has higher risk rate than it is for the Government. This weak point for individual to borrow at the risk-free expresses that the slope of the security market line is lower in practical way than it is in theory.
After analysing the assumptions of capital asset pricing model, the following paragraph will provide several advantages of capital asset pricing model. The model has superiority in calculating required return than other models.
The capital asset pricing model only takes systematic risk into consideration, the way it functioning represents most investors diversify portfolios from which non-systematic risks has been removed.
