CAPM Essay Sample

Almost everyone knows the simple concept of direct relationship between risk and return on investments. The underlying reason is clear: investors are not playing games, they work with real money, and would suffer real losses; therefore, they want ‘premium’ for taking excessive risk and the higher this risk, the more return they desire. However, the issue is estimating such risk, and more important is ability to measure the relationship between risk and return; in other words, investor want the answer on the question: how much exactly he will earn, if he invests in some asset with the given risk level. Actually, two benchmarks help to measure risk-return relationship: the first one is assets with no (zero) risk, which are usually government bonds like Treasury bills, and the second, market risk is the risk of portfolio of common stocks, that equals 1. However, another issue arise, particularly how to assess return if the risk does not equal nor zero neither 1? Three famous economists, Sharpe, Linter and Treynor, answered this question almost 50 years ago, and this answer is the probably not less well-known model, the Capital Asset Price Model (CAPM). This simple, and at the same time, startling method has been widely used by many economists and financial managers. Actually, the model predicts that increase in beta (risk) would lead to the proportional growth of return. Moreover, empirical data had perfectly supported this presumption. However, in the recent few decades the doubts regarding the relevance and accuracy of the CAPM has been on increase. Opponents of the applying the model to risk-return estimation has appealed to the wide range of reasons, starting from discrepancy of the model’s assumptions with the real life conditions to empirical evidence of the CAPM’s inconsistency. For example, one of the shortcomings of the model is that the estimation does not consider many other assets besides stock, as for example non-listed companies. Thus, the aim of this essay is making research regarding appropriateness of using the model in the modern financial management practice based on the recent empirical analyses, with the focus on the case of assessing risk and return for the non-listed companies.