Appendix 2 - Capital Asset pricing model (CAPM), Useful or Useless?

Capital Asset pricing model is a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.



The general idea behind capital asset pricing model is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a certain amount of time. The other half of the formula represents risk and calculates the amount of compensation the investor requires for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

Investors expect a risk premium for taking on risk above the risk free rate. Say that the expected return on a risk free asset, such as a government bond is 8%. You can earn 8% by investing into this type of asset without the risk of losing your money, as government bonds are assumed to be a safe investment. However, if a company wishes for you to invest into their company (by purchasing stocks) then they need to offer you a higher rate of return (a return above the risk free rate), as there is a risk that you will lose the capital you invested or won’t receive the expected returns you were promised. The additional return you receive for taking on the additional risk is referred to as the risk premium.

Graphing Capital Asset pricing model



Above table taken from Investopedia's official website indicates that the higher the risk the higher the returns for investors. Vertical axis measures the return of investment while the horizontal axis measures the risk taken.

Useful or Useless?
The capital asset pricing model has many critics. They cite expectations such as investors borrowing unlimited amounts at the risk-free rates, limitations which make for unrealistic assumptions and, ultimately, there are more accurate models such as APM or multifactor. It also is a one-period model and only looks at one moment in time and for these reasons many argue that the capital asset pricing model should no longer be the popular return-on-investment financial tool.

However many also believe in using capital asset pricing model.

In 2008 NY Times writer Paul Krugman described the CAPM as follows:

The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward — the so-called Capital Asset Pricing Model, or CAPM (pronounced cap-em) — is wonderfully elegant. And if you accept its premises it’s also extremely useful. CAPM not only tells you how to choose your portfolio — even more important from the financial industry’s point of view, it tells you how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators, and many of the theory’s adepts also received more mundane rewards: Armed with their new models and formidable math skills — the more arcane uses of CAPM require physicist-level computations — mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks.To be fair, finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive.

Many academic papers have investigated the real benefits of the CAPM. Douglas Breeden investigated the "empirical implications of the consumption orientated capital asset pricing model." What they found was that the CCAPM and the more standard CAPM performed similarly. Their paper Empirical Tests of the Capital Orientated CAPM was published in 1989 which shows how the CAPM's limited scope has been noticed before.

In conclusion, CAPM is a very good model for calculating risk and calculating return on investment, It has had much success over the last couple of decades but clearly has some limitations such as only looking at one period of time. An investor should look to use a range of models which will aid in making decisions and helping the investor fully understand the risks involved thus helping to reduce the riskiness of investing. Overall CAPM is a great model which determines the risks involved with certain investments and the likely capital return from taking part in the investment opportunity.