According to Fabozzi & Koln (2006), the Capital Asset Pricing Model (CAPM) is the works of Sharpe (1964) and Litner (1965) that marks the beginning of assets pricing theory. Dempsey (2013) asserts that CAPM still dominates the practical world in measuring systematic risk. CAPM offers a rate of return to compensate investors for taking risks. This model helps to calculate investment risk and the return on investment. CAPM reaches new heights as a model of measuring returns on securities. CAPM estimates the cost of capital for projects as well as evaluate the performance of portfolios in the financial market. Jagannathan & Meier, (2002) offer that CAPM model borrows from the Markowitz model where an investor evaluates a portfolio at time t to produce stochastic return at t.
The CAPM formula calculates the expected return on the security based on the level of the risk. This formula explains the relationship between the risk and the expected return. The Beta measures stock volatility in respect to the fluctuations in the market. Philips (2007) confirms that Fisher and Sholes cite a linear relationship between the financial returns of the beta and stock portfolios.
This model has the assumption that the investor is risk averse has only the concern of mean and variance in the investment return. Investors select a low mean and portfolio to minimize the variance of the expected return and maximize the return. CAPM uses algebra to assign weights on assets in the mean-variance efficient portfolios. The CAPM model relates risk and the expected return by identifying an efficient portfolio to clear the asset price for all assets in the market. MacKinlay, (1994) cites that CAPM model is subject to complete agreement assumption. In this case, the investors remain in agreement to distribute the asset return at a certain time. This model also assumes borrowing and lending at risk-free rate. Jagannathan & Meier, (2002) informs that the rate of borrowing and lending is same for all investors and not on amount since it is a variable. Additionally CAPM assumes perfect information to all investors such that they analyze information in the same way. Philip (2007) asserts that the investors in the market are price takers due to perfectly competitive security markets. The investors have the same belief concerning distribution of security returns. MacKinlay (1994) attests that CAPM assumes a single transaction period of twelve months to make comparable returns of the different securities. Levy (1980) specifies that investors can only hold diversified portfolios to make comparable returns.
CAPM gives an appropriate rate of return for any project and the market beta. An investment rate of return is lower when it offers better diversification due to the contribution of less risk. Market beta ascertains the risk of contribution. A project that contributes low risk requires a low expected rate of return. Dolde et al (2012) says that the graphical representation of CAPM model illustrates the security Market line that elaborates the relationship of expected rate of return and the beta return. All the projects must lie on a straight line.
Jagannathan & Meier (2002) mentions that, the empirical evidence that relates to CAPM occurs due to the expected return and the market beta. In this case, the expected return on all assets is in a linear curve in relation to the betas. The expected return on the portfolio exceeds the expected return on the assets. The assets that have no correlation with the market have equal risk-free rates betas. This test to support the evidence relies on a time-series regression model. The cross-section regression model that focus on the Sharpe-Lintner model in relation to expected return and the market beta. The model displays a positive relation between beta and the average return.
Gunasekaran & Ramaswami (2014) confirms evidence that signify the relation between beta and average return. The evidence relies on the Black and Sholes model that illustrate time-series regression of excess assets that are positive for assets with low betas. The Sharper-Lintner CAPM predicts portfolios along a straight line in relation to beta and the average return of the portfolios.
Rzakhanov (2012), evidence that common stocks based on earning is higher than the prediction of CAPM. Bornholt (2013), documents that stocks sorted on higher market capitalization is often higher than the prediction of CAPM. (Dolde et al., 2012) details that there is a high debt-equity
ratios associated with too high returns in relation to the market betas.( De Giorgi & Post, 2008) finds that the price of a stock is in tandem the expected cash flows and the expected returns that discount the cash flows. Levy (1981) finds that CAPM has a better pricing method than dividend growth model in calculating equity. In this case, CAPM takes into account the systematic risk in relation to the stock market. (Bornholt, 2013) evidence that the stocks that have high book-market ratios experience high returns. The cross-section prices inform investors on the expected returns. The ratios in a stock price expose the pitfall of the CAPM model. The asset pricing model elaborate that earning-price and debt-equity ratio predict the market betas.(Borche, 1982)illustrates the failure of CAPM using regression approach to the book- market ratios.
The academic community is turning away from the CAPM model since the asset pricing is not practical in a real world. (Baker, 1997) document that well developed stock markets portrays efficiency while the stock market prices appear incorrectly in the Security Market Line (SML).(Engel, 1986) synthesize the evidence concerning the failure of CAPM using United States data. The stock returns depict contradictions of CAPM present in the emerging markets. The price ratios in this data are not sample specific. (Brown & Walter, 2013) confirm that CAPM suffers from the assigning of variables. These variables do not rely on the equity risk premium or rate on the market. CAPM fails to yield on the government debt that is not fixed to the impending economic situations. McEnally (1978) elaborates that it is not possible for the investors to borrow at risk free rate to yield the short-term government debt. (Fabozzi & Koln, 2006) finds that CAPM assumes the holding of diversified portfolios that is expensive in the face of unsystematic risk. Treynor (1993) asserts that it is difficult to assign ERP values. In the event there is a fall in price of shares, the stock market can provide a negative return. Dolde & O’Brien (2012) explain that problems emerge in the event of using CAPM to appraise projects. It is difficult for companies to allocate suitable proxy betas. It is also difficult to obtain information on the relative shares. Baker (1997) mentions that the assumption of CAPM to apply a single period affects the multi period project appraisal. CAPM variables assume constant for the future period that is not the practice in reality. The portfolios of CAPM produce negative average of returns in relation to the market betas.
According to empirical test and research, CAPM model developed by Sharpe (1964) and Lintner (1965) has been fruitful. The latter version of Black and Sholes model (1972) that applies the average return for market beta also succeeds. The financial analysts and economists recommend the Sharpe-Lintner model of asset pricing model. In this model, the market beta combines with risk-free interest rate to estimate the cost of capital. CAPM is a useful financial management technique.
References
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