The Capital Asset Pricing Model: A Critique

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 "SharpeLintnerMossin capital asset pricing model," and employs the variance in expected return of an investment as the measure of ri

. . .
ling will not affect stock prices). 7. The quantities of all assets are given. Although it is, at once, obvious that several of the basic assumptions have little or no relevance to the actual conditions which are encountered by investors, nevertheless, the assumptions do permit the derivation of relationships between specific securities and the market as a whole. Thus, the derived risk premium will likely be valid, although the model would not likely be successful in the derivation of a base price for the security (which, it must be added, is not the purpose of the CAPM). If the theoretical assumptions of the capital assets pricing model can be accepted and if values can be assigned to a riskfree rate of return and to the market price of risk, then the risk premium can be expressed as being proportional to the expected rate of return on a market index (Starshad, 1982, p. 830). Functioning Essential elements in the functioning of the capital assets pricing model include (1) the market portfolio, (2) the capital market line, (3) the security market line, and (4) the beta coefficient. The market portfolio is a combination of all securities active in a market. Each of these securi
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Approximate Word count = 1462
Approximate Pages = 6 (250 words per page)

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