CAPM

CAPM is dead in the context of asset returns

CAPM is dead in the context of asset returns

Introduction

The Capital Asset Pricing Model is an important contribution in corporate finance which is widely used for determining prices of assets or stocks based on their expected returns by taking consideration of their corresponding level of systematic risks. It is the most widely used and argued model for asset pricing. (Modigliani and Pogue, 1947, pp.73) “CAPM is based on elementary logic and simple economic principles.” Where as recent theories emphasised that CAPM is not the only model that is justified for determination of asset prices based on their returns, as it only considers the systematic risk which can not be diversified or minimized through holding a diversified portfolio, irrespective of macro factors which certainly can affect the asset returns. These macro factors may include size of investments and book value to market value of assets which can affect the expected returns of asset.

Discussion

To illustrate the topic assigned i.e., CAPM is dead in context of asset rerturns some basic things should be illustrated. So staring with the overview of the portfolio theory to describe CAPM and its basics, I will be discussing the implications and its consequences, with respect to the affects of cross section of average return on assets.

Overview of Portfolio Theory

The modern theory of investment was given birth when in 1950 Markowitz coined the portfolio theory. Before this theory, investors were not aware of the diversification concept that implies a saying “do not put your all eggs in one basket.” The first theorist to develop the concept of diversification mathematically through portfolio theory was Markowitz, which suggests investors to invest and hold a mix of assets to reduce risk. The risk is diversified if the asset in the portfolio is not positively co-related. This not only minimizes the risk factor but also helps investors to attain maximum possible expected returns in accordance with certain level of risk or to realize least amount of risk for a assumed expected return level by constituting a well diversified portfolio. The assumption for this theory is that the investors only care for the mean and variance of the return. For this reason the theory is also called as mean-variance analysis and the investors are mean-variance optimizer. This implies that in general investors are risk averse prefers lowest possible risk for a certain level of expected return. For this reason the dispersion of variance in possible expected return is also taken as a measure of risk.

According to the portfolio theory, the portfolio frontier shows almost all combinations of assets held by a portfolio. Asset diversificaiotion can shift the portfolio frontier to the left, hence lowering the risk for given expected return. The positive gradient indicates all the efficient portfolios with less risk on the portfolio frontier. Rational investors normally tends to maximize assets returns in respect of its variance or risk, therefore the positive slope holds the optimal portfolio, and when introduced a risk free asset (Ro), the ...