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The Capital asset Pricing Model (CAPM) isn't wrong. It just doesn't go far enough

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  1. Introduction.
  2. The capital asset pricing model (CAPM) theory.
  3. A high-beta stock.
  4. The approach recommended by most investment fundamentalists.
  5. The attraction of the CAPM.
  6. The economic interpretation of the CAPM equation.
  7. Treasury bond.
  8. The market portfolio.
  9. Conclusion.
  10. Bibliography.

The capital asset pricing model (CAPM) is a mathematical model that explains the relationship between risk and return in a rational equilibrium market. The model is used in finance to determine a theoretically appropriate required rate of return asset, if that asset is to be added to an existing well-diversified portfolio, provided that asset's non-diversifiable risk. The CAPM formula takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (a) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset.
The capital asset pricing model (CAPM) theory assumes that an investor expects a yield on a certain security equivalent to the risk free rate (say that rate achievable on six-month Treasury bills) plus a premium based on market variability of return X a market risk premium. In Winter 1991, the m?rket risk premium on listed U.S. common stocks appears to have been about 6.5%, according to statistics published in the Quarterly Review, Winter 1991, by the Federal Reserve Bank of New York (though the Ibbotson study found it to exceed 8% from the mid 1920s through 1987). Thus in a period of 4% inflation, the T-bill rate might be appropriately 4.5 to 5%; a four- or five-year Treasury note should have a yield of 5.5 to 6%; Treasury bonds should yield a percent higher than this; and corporate bond yields should have even higher returns to compensate for their additional credit or business risk.

[...] Bec?use C?PM prices ? stock in terms of ?ll stocks ?nd bonds, it is re?lly ?n ?rbitr?ge pricing model which throws no light on how ? firm's bet? gets determined. It is possible th?t the C?PM holds, the true m?rket portfolio is efficient, ?nd empiric?l contr?dictions of the C?PM ?re due to b?d proxies for the m?rket portfolio. The model c?lls for the m?rket portfolio of invested we?lth, but the m?rket proxies used in empiric?l work ?re ?lmost ?lw?ys restricted to common stocks. [...]


[...] The C?PM is good for ev?lu?tion of investment projects but it is not enough for the investor to rely on this model only. The m?jor shortcoming of the model is th?t it ?ssumes th?t ?sset returns ?re norm?lly distributed r?ndom v?ri?bles. It is however frequently observed th?t returns in equity ?nd other m?rkets ?re not norm?lly distributed. ?s ? result, l?rge swings to 6 st?nd?rd devi?tions from the me?n) occur in the m?rket more frequently th?n the norm?l distribution ?ssumption would expect. [...]


[...] Unfortun?tely, the empiric?l record of the model is poor-poor enough to inv?lid?te the w?y it is used in ?pplic?tions. The C?PM's empiric?l problems m?y reflect theoretic?l f?ilings, the result of m?ny simplifying ?ssumptions. But they m?y ?lso be c?used by difficulties in implementing v?lid tests of the model. For ex?mple, the C?PM s?ys th?t the risk of ? stock should be me?sured rel?tive to ? comprehensive "m?rket portfolio" th?t in principle c?n include not just tr?ded fin?nci?l ?ssets, but ?lso consumer dur?bles, re?l est?te ?nd hum?n c?pit?l. [...]

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