Capital Asset Pricing Model

The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), in a number often referred to as beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.

Assumptions of CAPM

* All investors have rational expectations.
* All investors are risk averse.
* There are no arbitrage opportunities.
* Returns are distributed normally.
* Fixed quantity of assets.
* Perfect capital markets.
* Separation of financial and production sectors.
o Thus, production plans are fixed.
* Risk-free rates exist with limitless borrowing capacity and universal access.

[edit]

Shortcomings of CAPM

• The model does not appear to adequately explain the variation in stock returns. Empirical studies show that low beta stocks may offer higher returns than the model would predict. Some data to this effect was presented as early as a 1969 conference in Buffalo, New York in a paper by Fischer Black, Michael Jensen, and Myron Scholes. Either that fact is itself rational (which saves the efficient markets hypothesis but makes CAPM wrong), or it is irrational (which saves CAPM, but makes EMH wrong – indeed, this possibility makes volatility arbitrage a strategy for reliably beating the market).

(See Good and bad betas for a response.)

• The model assumes that investors demand higher returns in exchange for higher risk. It does not allow for investors who will accept lower returns for higher risk. Casino gamblers clearly pay for risk, and it is possible that some stock traders will pay for risk as well.
• The model assumes that all investors agree about the risk and expected return of all assets.
• The model assumes that there are no taxes or transaction costs, although this assumption may be relaxed with more complicated versions of the model.
• The model assumes that asset returns are lognormally distributed, random variables. There is significant evidence that equity and other markets are complex, chaotic systems. As a result, large swings (3 to 6 standard deviations from the mean) occur in the market more frequently than the normal distribution assumption would expect. These swings can greatly impact an asset's value.
• The market portfolio consists of all assets in all markets, where each asset is weighted by its market capitalization. This assumes no preference between markets and assets for individual investors, and that investors choose assets solely as a function of their risk-return profile. It also assumes that all assets are infinitely divisible as to the amount which may be held or transacted.
• The market portfolio should in theory include all types of assets that are held by anyone as an investment (including works of art, real estate, human capital...) In practice, such a market portfolio is unobservable and people usually substitute a stock index as a proxy for the true market portfolio. Unfortunately, it has been shown that this substitution is not innocuous and can lead to false inferences as to the validity of the CAPM, and it has been said that due to the inobservability of the true market portfolio, the CAPM might not be empirically testable.