Monday, November 30, 2009


Implications and Relevance of Capital Asset Pricing Model

Capital asset pricing model (CAPM) based on a number of assumptions. Given those assumptions, it provides a logical basis for measuring risk and linking risk and return.
Capital asset pricing model (CAPM) has the following implications,

  • Investors will always combine a risk free asset with a market portfolio of risky assets. They will invest in risky assets in proportion to their market value.
  • Investors will be compensated only for that risk which they cannot diversify. This is the market related systematic risk. Beta which is a ratio of the covariance between the asset returns and the market returns divided by the market variance is the most appropriate measure of an asset’s risk.
  • Investors can expect returns from their investment according to the risk. This implies a liner relationship between the asset’s expected return and its beta.
The concepts of risk and return as developed under capital asset pricing model (CAPM) have intuitive appeal and they are quite simple to understand. Financial managers use these concepts in a number of financial decisions making such as valuation of securities, cost of capital measurement, investment risk analysis excreta. However in spite of its intuitive appeal and simplicity capital asset pricing model (CAPM) suffers from a number of practical problems.
Limitations of Capital asset pricing model
Capital asset pricing model has the following limitations,
  1. It is based on a number of unrealistic assumptions.
  2. It is difficult to test the validity.
  3. Betas do not remain stable over time. (Beta is a measure of a security’s risk).

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