Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model (CAPM)

What are the main limitations of CAPM in terms of its applicability to forecasting returns for a given stock? What does it mean when a stock has positive alpha?

Answer

Introduction

Capital Asset Pricing Model (CAPM) is one of the models for asset pricing. Others are Arbitrage Pricing Theory (APT) and the Black-Scholes option pricing model. CAPM is a simple model and usually easier to compute because of the availability of the information on the parameters. However, it has been widely criticized for its assumptions and limitations.

CAPM’s Limitations

CAPM, developed by William F Sharpe, is a single factor model for estimating investment asset returns. It sought to show a correlation between expected returns and risks. This formula summarizes CAPM, which is:

Rs = Rf + β (Rm-Rf)

Rs = Expected/Required Return on the investment

Rf = Risk-free Return (that can be earned on a risk-free investment)

Rm = Average return on all securities in the market

β = The securities beta (systematic) risk factor that cannot be diversified

CAPM had some limitations, informed by its assumptions that were unrealistic. It assumes that every borrower could access investment capital at the risk-free rate usually benchmarked on government securities widely thought to be risk-free. But the fact is that these rates can be volatile on a daily basis. In essence, there are no entirely risk-free securities in the market. Additionally, the government issued securities are subject to inflation pressures. Therefore, this could affect the real rate of return (Sigman, 2005).

CAPM also assumes equality of borrowing and lending rates. This is not possible because lenders and borrowers profiles of debt assumption capacities are different. It is also not easy to assess the validity of CAPM. Betas do not remain stable over time and may fail to establish the actual systematic risk of the proposed investment accurately (Aukea, et al. 2017).

CAPM assumes a perfect straight-line situation that an individual investor will hold a fully diversified investment portfolio. Investors are different with different risk appetites as well as different investor behavior. CAPM assumes that all individual investors seek to maximize the expected utility of their investment portfolios over a single period (Aukea, et al. 2017). It assumes the market is perfect. That there are no taxes and other transaction costs and that the market is competitive. It also relies on historical returns and viability of stock performances and ignores possible market changes in the future. CAPM assumes that all investors have similar risk appetite and that the higher the risk considered by an individual, the higher the return. It ignores markets forces of demand and supply as well as investor panic. That investment will happen under perfect competition assumption of microeconomics. But forces of demand and supply usually determine the prices (Aukea, et al. 2017).

Positive Alpha

Alpha is the amount by which the returns from any given asset exceed the returns from the broader market. An asset that consistently gives higher returns than a broad based market portfolio is said to have positive alpha (Aukea, et al. 2017).

References

Aukea, L., Diagne, A., Nguyen, T., Stalin, O., (2017, May 15). The Capital Asset Pricing

Model and the Arbitrage Pricing Theory. Retrieved from

http://www.math.chalmers.se/Stat/Grundutb/CTH/mve220/1617/CAPT.pdf

Foster, D., Stine, R., Young, H., (2011, September 8). A Markov Test for Alpha.

Retrieved from http://www.econ2.jhu.edu/people/young/FosterStineYoung8Sept.pdf

Sigman, K., (2005). Capital Asset Pricing Model (CAPM). Retrieved from

http://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-CAPM.pdf

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