CAPITAL ASSET PRICING MODEL (CAPM)

Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

Critically evaluate the role of Capital Asset Pricing Model (CAPM) in modern portfolio management.

The capital asset pricing model (CAPM) is a mathematical model that seeks to explain the relationship between risk and return in a rational equilibrium market. Developed by academia, the CAPM has been employed in applications ranging from corporate capital budgeting to setting public utility rates. The CAPM provides much of the justification for the trend toward passive investing in large index mutual funds.

William Sharpe, John Lintner, and Jan Mossin simultaneously and independently developed the CAPM. Their research appeared in three different, highly respected journals during the period of 1964-66. When the CAPM was first introduced, the investment community viewed the new model with suspicion, since it seemed to indicate that professional investment management was largely a waste of time. It was nearly a decade before investment professionals began to view the CAPM as an important tool in helping investors understand risk.

The key element of the model is that it separates the risk affecting an asset's return into two categories. The first type is called unsystematic, or company-specific, risk. The long-term average returns for this kind of risk should be zero. The second kind of risk, called systematic risk, is due to general economic uncertainty. The CAPM states that the return on assets should, on average, equal the yield on a risk-free bond held over that time plus a premium proportional to the amount of systematic risk the stock possesses.

The treatment of risk in the CAPM refines the notions of systematic and unsystematic risk developed by Harry M. Markowitz in the 1950s. Unsystematic risk is the risk to an asset's value caused by factors that are specific to an organization, such as changes in senior management or product lines. For example, specific senior employees may make good or bad decisions or the same type of manufacturing equipment utilized may have different reliabilities at two different sites. In general, unsystematic risk is present due to the fact that every company is endowed with a unique collection of assets, ideas, personnel, etc., whose aggregate productivity may vary.

A fundamental principle of modern portfolio theory is that unsystematic risk can be mitigated through diversification. That is, by holding many different assets, random fluctuations in the value of one will be offset by opposite fluctuations in another. For example, if one fast food company makes a bad policy decision, its lost customers will go to a different fast food establishment. The investor in both companies will find that the losses in the former investment are balanced by gains in the latter.

Systematic risk is risk that cannot be removed by diversification. This risk represents the variation in an asset's value caused by unpredictable economic movements. This type of risk represents the necessary risk that owners of a firm must accept when launching an enterprise. Regardless of product quality or executive ability, a firm's profitability will be influenced by economic ...