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11/27/2015 The Advantages And Disadvantages Of The CAPM Model
http://www.investopedia.com/articles/investing/021015/advantagesanddisadvantagescapmmodel.asp 1/4
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The The capital asset pricing model (CAPM)capital asset pricing model (CAPM) is a widely-used finance theory that establishes a is a widely-used finance theory that establishes a
linear relationship between the linear relationship between the required returnrequired return on an investment and risk. The model is on an investment and risk. The model is
based on the relationship between an asset's based on the relationship between an asset's betabeta, the , the risk-free raterisk-free rate (typically the Treasury (typically the Treasury
bill rate) and the bill rate) and the equity risk premiumequity risk premium (expected return on the market minus the risk-free (expected return on the market minus the risk-free
rate).rate).
At the heart of the model are its underlying assumptions, which many criticize as beingAt the heart of the model are its underlying assumptions, which many criticize as being
unrealistic and might provide the basis for some of the major drawbacks of the model.unrealistic and might provide the basis for some of the major drawbacks of the model.
DrawbacksDrawbacks
Like many scientific models, the CAPM has its drawbacks. The primary drawbacks areLike many scientific models, the CAPM has its drawbacks. The primary drawbacks are
reflected in the model's inputs and assumptions.reflected in the model's inputs and assumptions.
Risk-free Rate (RRisk-free Rate (Rff): The commonly accepted rate used as the R): The commonly accepted rate used as the Rff is the yield on is the yield on short-short-
term government securitiesterm government securities. The issue with using this input is that the yield changes. The issue with using this input is that the yield changes
daily, creating volatility.daily, creating volatility.
Return on the Market (RReturn on the Market (Rmm): The return on the market can be described as the sum of): The return on the market can be described as the sum of
the the capital gainscapital gains and and dividendsdividends for the market. A problem arises when at any given time, for the market. A problem arises when at any given time,
the market return can be negative. As a result, a long-term market return is utilized tothe market return can be negative. As a result, a long-term market return is utilized to
smooth the return. Another issue is that these returns are backward-looking and maysmooth the return. Another issue is that these returns are backward-looking and may
not be representative of future market returns.not be representative of future market returns.
Ability to Borrow at a Risk-free Rate: CAPM is built on four major assumptions,Ability to Borrow at a Risk-free Rate: CAPM is built on four major assumptions,
including one that reflects an unrealistic real-world picture. This assumption, thatincluding one that reflects an unrealistic real-world picture. This assumption, that
investors can borrow and lend at a risk-free rate, is unattainable in reality. Individualinvestors can borrow and lend at a risk-free rate, is unattainable in reality. Individual
investors are unable to borrow (or lend) at the rate the US government can borrow at.investors are unable to borrow (or lend) at the rate the US government can borrow at.
Therefore, the minimum required return line might actually be less steep (provide aTherefore, the minimum required return line might actually be less steep (provide a
lower return) than the model calculates.lower return) than the model calculates.
Determination of Project Proxy Beta: Businesses that use CAPM to assess an investmentDetermination of Project Proxy Beta: Businesses that use CAPM to assess an investment
need to find a beta reflective to the project or investment. Often a proxy beta isneed to find a beta reflective to the project or investment. Often a proxy beta is
necessary. However, accurately determining one to properly assess the project isnecessary. However, accurately determining one to properly assess the project is
difficult and can affect the reliability of the outcome.difficult and can affect the reliability of the outcome.
AdvantagesAdvantages
Despite the aforementioned drawbacks, there are numerous advantages to the application ofDespite the aforementioned drawbacks, there are numerous advantages to the application of
CAPM.CAPM.
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AAAABy By Kristina Zucchi, CFAKristina Zucchi, CFA | February 10, 2015 | February 10, 2015
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11/27/2015 The Advantages And Disadvantages Of The CAPM Model
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CAPM.CAPM.
Ease-of-use: CAPM is a simplistic calculation that can be easily stress-tested to derive aEase-of-use: CAPM is a simplistic calculation that can be easily stress-tested to derive a
range of possible outcomes to provide confidence around the required rates of return.range of possible outcomes to provide confidence around the required rates of return.
Diversified Portfolio: The assumption that investors hold a diversified portfolio, similarDiversified Portfolio: The assumption that investors hold a diversified portfolio, similar
to the market portfolio, eliminates to the market portfolio, eliminates unsystematic (specific) riskunsystematic (specific) risk..
Systematic RiskSystematic Risk (beta): CAPM takes into account systematic risk, which is left out of (beta): CAPM takes into account systematic risk, which is left out of
other return models, such as the other return models, such as the dividend discount modeldividend discount model (DDM). Systematic or market (DDM). Systematic or market
risk is an important variable because it is unforeseen and often cannot be completelyrisk is an important variable because it is unforeseen and often cannot be completely
mitigated because it is often not fully expected.mitigated because it is often not fully expected.
Business and Financial Risk Variability: When businesses investigate opportunities, ifBusiness and Financial Risk Variability: When businesses investigate opportunities, if
the business mix and financing differ from the current business, then other requiredthe business mix and financing differ from the current business, then other required
return calculations, like return calculations, like weighted average cost of capitalweighted average cost of capital (WACC) cannot be used. (WACC) cannot be used.
However, CAPM can.However, CAPM can.
The Bottom LineThe Bottom Line
No model is perfect, but each should have a few characteristics that make it useful andNo model is perfect, but each should have a few characteristics that make it useful and
applicable. CAPM, while criticized for its unrealistic assumptions, provides a more usefulapplicable. CAPM, while criticized for its unrealistic assumptions, provides a more useful
outcome than either the DDM or WACC in many situations. It is easily calculated and stress-outcome than either the DDM or WACC in many situations. It is easily calculated and stress-
tested. And when used in conjunction with other aspects of an investment mosaic, it cantested. And when used in conjunction with other aspects of an investment mosaic, it can
provide unparalleled yield data that can support or eliminate a potential investment.provide unparalleled yield data that can support or eliminate a potential investment.
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Q: Q: What is the formula for calculating the capital asset pricing model (CAPM)?What is the formula for calculating the capital asset pricing model (CAPM)?The capital asset pricing model, or CAPM, is a calculation used in corporate finance to determine theThe capital asset pricing model, or CAPM, is a calculation used in corporate finance to determine the
projected return generated ... projected return generated ... Read Full Answer >>Read Full Answer >>
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model, or CAPM, to estimate ... model, or CAPM, to estimate ... Read Full Answer >>Read Full Answer >>
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