Critically evaluate CAPM Model.

CAPM – Capital asset pricing model

This model simply defines the relationship between risk of an asset (systematic risk) and expected
return. This helps in providing a benchmark return for evaluating the investment. CAPM uses the
concept of modern portfolio theory to know if the security is fairly priced. While analyzing the security
we will be interested in whether the above predicted return is more than or less than the fair value of
return for given risk.

Following is the equation:

Eri = rf + β (Erm-rf)

Where Eri = expected rate of return

rf = risk free rate

β = beta shows systematic risk

(Erm-rf) = market risk premium

Rf is the risk free rate. It is usually proxied by investment in government securities.

Beta is measure of stock risk. Beta is systematic risk that cannot be eliminated by diversification. It
measures a stock relative volatility, how much the price of share up and down with the jump in the price
of entire stock market. If price are in linear with the entire market then value of beta comes out as 1. If
say its 1.5 then if market rise by 10% stock will rise by 15% or if market fall by 10% it fall by 15%, it
simply says risk level is grater then market average.

Market risk premium is given by excess return over and above risk free rate. It can be said as
compensation for investing in riskier class.

Elements of CAPM:

1. Capital market line (CML): CML is special case of capital allocation line. If all the investors have
same optimal risky portfolios due to same input list and homogenous expectations, then optimal
market portfolio will be market portfolio and the capital allocation line will be capital market line
now.
CML outline the efficient portfolio by using risk return trade off. By this way we achieve point
where we get combination with highest return and minimum risk.
2. Security market line: SML is the main result of CAPM. It is a graphical representation depicts the
relationship between systematic risk, beta, and returns of a portfolio. We show beta on x axis
and returns on y axis. Security market line provides benchmark for the evaluation of investment
performance and the pricing of asset. For given beta, SML provides return to compensate for
the risk taken and the time value of money.
 When we plot the security on SML chart, Undervalued stocks are plotted above the SML and
overpriced stocks are pointed under the SLM. SLM is also used to compare the similar securities
offering same rate of return, to know which one of them involves the least amount of risk.
Similarly we can compare two securities of same risk, which one of them offers higher rate of
return. SML will be represented by the expected return-beta relationship as:

Eri = rf + β (Erm-rf)

In equilibrium all the asset will lie on the SML. The difference between fair expected return and
the actually expected return is denoted by alpha. Every portfolio manager prefers to increase
the weight of the securities that have positive alpha.

The assumptions made by CAPM model is:

1. Individual behavior
a) Investors are rational, mean variance optimizers: Investors are expected to take
investment decisions on the basis of risk and return. CAPM assumes that rational investors
put away their unsystematic risk and only systematic risk varies with beta of the security.
b) Investors use identical input lists, is called homogeneous expectations: all the investors
have same input list means their risk and return estimates are same. Investors who trade on
different input lists will offset and prices will reflect consensus expectation.
c) Their planning horizon is single period: Investors make their decision based on single time
horizon. Single period model is convenient because multi period models become very
difficult however there is a shortcoming with this assumption.
2. Market structure
a) All the assets are publicly traded (short positions are allowed) and investors can borrow or
lend at a common risk-free rate: This assumption says all the assets are publicly traded and
the risk free rate will remain constant. But this assumption suffers from great limitation
which we will discuss further.
b) All the information is publicly available: This implies that investors have complete
knowledge of the market and the securities they invest in.
c) No taxes: it assumed that there are no taxes and taxes do not affect the selection of
portfolio.
d) No transaction costs: this assumes that transaction costs are very low that they can be
ignored. But in reality it plays an important role in stock return.

CAPM is based on the assumptions which might be different from the real world situations. Due to this
fact it faced some criticisms and challenges.

Criticism and Challenges to above assumptions

Some of the above mentioned assumptions are very unrealistic.

1. Let’s start with getting short positions in addition with securities are tradable at large
(assumption 2A). Many investment companies are prohibited from short sales and different
countries have different short sales regulations. In some countries short selling is banned.
In addition to this investors cannot find sufficient number of shares to borrow to get short
position.
2. Assumption 1B says investors have homogeneous expectation but if this is the case there will
be no buying and selling, but there is lot of buying and selling in the market which indicates that
people have heterogeneous expectations.
3. Assumption 2A says that all assets are tradable but in reality this is not. For example labor
income and private business. They have excluded large portion of part coming from private
business and labor income. This violates the assumption of CAPM, we will get flatter CAPM.
4. Assumption 1C has taken into account the single time horizon. If People believe that interest
rate may go down, now the people who have invested in risk free rates will go for long term
bonds. Because long term bonds are hedge against decline in interest rates. The prices will go up
and yield will go down this will violates CAPM.
Extension of CAPM:
1. Zero beta model:
Merton says on efficient frontier, every portfolio has companion portfolio which is uncorrelated
with the efficient portfolio. This companion portfolio is called zero beta portfolios.
If people are facing differential borrowing and lending rate they won’t buy market portfolio,
there are portfolios which have zero correlation with efficient portfolios and by combining them
we arrived at new SML or zero beta model. As a result of this people will go for high beta stocks
prices may go down and SML will be flatter (than the simple CAPM). Due to SML flattening of
line CAPM will be violated.
In simple words, when risk free investment is restricted and all other assumptions of standard
CAPM holds true, simple version is replaced by zero beta version.

Equation: Eri = E(rz)+ β (Erm- E(rz))

In the above equation E(r z) stands for expected return on zero beta portfolio and is always
greater than rf because rf is risk free possess no sort of risk and (rz) contains some source of risk.

2. Labor income and non-traded assets

We have already discussed that all assets are tradable does not include human capital and
privately held business. The size of labor income is of great concern for the validity of CAPM.
Considering this Mayers derived a CAPM for an economy in which non-traded assets exist;
specifically an economy in which individuals are endowed with human capital.
 CAPM risk measure beta is replaced by adjusted beta.
 In this model SML is less steep than that of standard CAPM.
3. Multiperiod model
In simple version of CAPM we have assumed that investors have a single period time
horizon. But Merton relaxed this assumption and gave a model called inter temporal
 capital asset pricing model (ICAPM). He came up with concept for extra market source of
risk which says that there is inflation risk or consumption related risk other than systematic
risk beta. When investor tastes and security returns changes over time or investors seeks to
hedge non market sources of risk then this gives a way to multiperiod version. In this model
investor’s exposure to non-market source of risk will fetch premium.
4. CCAPM (consumption based capital asset pricing model): In this model market portfolio
excess return is replaced by consumption tracking portfolio. But the problem arises with this
model is that all the consumable assets do not trade; hence it is difficult to create portfolio.
Conclusion:
This model represents a simple theory with simple result. It provides a useful measure that
help investors what they return they deserve on their investments for putting their money
in the risky class. The model faced lot of criticism but still it is widely used.