The purpose of this research is to analyze and critique the capital asset pricing model (CAPM). The analysis and critique are presented in separate discussions.
Analysis of the CAPM is considered in three contexts. These discussions are related to (1) background on the model, (2) describing the model, and (3) the functioning of the CAPM.
Background
The capital asset pricing model was originally developed (and is still applied, primarily) to securities management.
Sharpe (1988, p. 153) stated that securities
. . . prices are the result of different analyses of somewhat different sets of information, along with different conditions and preferences relevant for various investors. One analyst's estimates of risk and return for a security are likely to differ from those of other analysts. Since both risk and return are subjective estimates dealing with the future, there is ample room for disagreement . . . These differences make . . . it impossible to categorically measure risk and return and the relationship between them.
The capital asset pricing mode was developed as a "simple, yet powerful description of the relationship between risk and return in an efficient market" (Sharpe, 1988, p. 144). The basic model is referred to as the "Sharpe Lintner Mossin capital asset pricing model," and employs the variance in expected return of an investment as the measure of risk (Starshak, 1982, p. 830). Goldberg and Vora (1978, p. 439) trace the development of the quantitative capital asset pricing model to the introduction of his portfolio theory by Markowitz in 1952.
Description
The capital asset pricing model is based on the relationship between the risk of a specific security and the overall risk of the market. This relationship is known as beta. The beta coefficient of a security is used to determine the level of the market risk ...