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Thursday, April 10, 2014

Problems with the Capital Asset Pricing Model (CAPM)

If the Capital Asset Pricing Model could be summarized in one sentence it might be something like this: A set of mathematical assumptions compiled in to a formula that's variables measure yield as a function of risk and rate of return. Among the many assumptions made within the CAPM and presented in the slide show that follows are that the model adequately measures the variability of stock market returns in addition to failing to include all possible assets in its evaluation of returns. These alone are big pre-suppositions that may render the CAPM symbolic of the dream of quantitative finance and make it more of a rough estimate akin to back of the envelope financial calculations. The Investopedia definition of the CAPM includes the formula below, and although it seems savvy and complex, it is actually very limited:
Capital Asset Pricing Model (CAPM)

The problem with CAPM accuracy is complicated by the weakness of "beta" as a risk management metric per the Saxo Bank Group. Moreover, since beta is essentially a correlation with an index such as the S&P 500 it is more a measure of an individual security or asset's relationship with a broader market rather than risks unique to that particular financial instrument. For example, beta does not measure internal company or asset risks such as those caused by high employee turnover or unforeseen technological mishaps within day-to-day business operations among other things.

Financial Mgt. - Capital Asset Pricing Model from Kaustabh Basu

An additional problem with the CAPM is pointed out in the E-book Fundamentals of Corporate Finance published by McGraw-Hill. More specifically, not only is beta a limited measurement in terms of internal corporate matters, but also as a consistently precise measurement. Moreover, since liquidity is different for various assets, the measurement of risk is imprecise in so far as precision is influenced by trading volume. Thus, stocks with higher liquidity will be more highly correlated to the index than less liquid securities.  

Despite its disadvantages, the CAPM does have some practical uses. Since it is based on market performance and a risk metric based on that market performance, the CAPM does serve as measure of yield within those systematic confines. In other words, for a highly liquid asset that is very correlated to maket performance, the CAPM is a good measure of yield. It is also used as an alternative method of measuring cost of equity. Since it forecasts future yield expectations in terms of the market, the CAPM gives a reasonable representation of what investors will also expect.

Some of the relevance of the CAPM is evident in its history. One of the creators of the CAPM named William Sharpe was awarded a Nobel Prize for the financial thought surrounding the model per Edward J. Sullivan of Lebanon Valley College. It may be difficult to believe that something as inadequate and insufficient as the CAPM received such recognition, but that might be missing the point. The CAPM represents a quantification of securities valuation in terms of risk, which in a sense pioneered, or for a time, led the way to a more accurate and sophisticated form of finance.  In other words, the Nobel Prize seems to be more about the direction it takes financial thought more than how well it goes in that direction.