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First, as mentioned previously, this model assumes that investors are risk avoiders who want to maximize their wealth within the period. Specifically, the CAPM is a one period model. It also generalizes all investors as having the same belief on returns, they receive all costless information simultaneously, and there is a frictionless, perfectly competitive market. Next, it assumes there are risk-free assets that are without restraint and at a constant rate. It also does not take into account human capital, taxation, regulations, or restrictions on short selling. Incidentally, even though these assumptions and others are not usually met in reality, the CAPM still remains as one of the most widely used tools for determining expected return and risk when investing in market portfolios (Value Based Management 2008).
Flaws and Rewards
The Capital Asset Pricing Model (CAPM) has been used for over 40 years. It is often preferred over other pricing models. Why is this? Do the rewards of using CAPM outweigh the flaws or risks? In researching the CAPM, many flaws to the model were pointed out. One person to point out flaws of the theory is one of its own developers, William Sharpe; who is revamping the original …show more content…
According to individuals that are strong followers of beta, they argue that beta is a useful tool, as it has appealed to be a proxy risk tool. Beta is said to be a tool that offers a clear, quantifiable measure, which makes it easy to work with. It's also said to be a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows.
When we look at the weaknesses of beta, it has been stated that when investing in a stock's fundamentals, beta has plenty of shortcomings such as providing information. It has been said that beta does not include new information when investing in a stocks fundamental. When looking at this topic, information provided at Investopedia.com used the Electric Utility Company, American Electric Power (AEP), as an example. Here it was stated that when looking at this in a historical view, AEP has been considered a defensive stock, which is a stock that provides a constant dividend and stable earnings regardless of the state of the overall stock market, with a low beta. But when it entered the merchant energy business and assumed high debt levels, AEP's historic beta no longer capable to capture the substantial risks the company took on. Beta is also said to another troubling factor. This troubling factor is known to be a past price movement. It is stated that past price movements
Flaws and Rewards
The Capital Asset Pricing Model (CAPM) has been used for over 40 years. It is often preferred over other pricing models. Why is this? Do the rewards of using CAPM outweigh the flaws or risks? In researching the CAPM, many flaws to the model were pointed out. One person to point out flaws of the theory is one of its own developers, William Sharpe; who is revamping the original …show more content…
According to individuals that are strong followers of beta, they argue that beta is a useful tool, as it has appealed to be a proxy risk tool. Beta is said to be a tool that offers a clear, quantifiable measure, which makes it easy to work with. It's also said to be a convenient measure that can be used to calculate the costs of equity used in a valuation method that discounts cash flows.
When we look at the weaknesses of beta, it has been stated that when investing in a stock's fundamentals, beta has plenty of shortcomings such as providing information. It has been said that beta does not include new information when investing in a stocks fundamental. When looking at this topic, information provided at Investopedia.com used the Electric Utility Company, American Electric Power (AEP), as an example. Here it was stated that when looking at this in a historical view, AEP has been considered a defensive stock, which is a stock that provides a constant dividend and stable earnings regardless of the state of the overall stock market, with a low beta. But when it entered the merchant energy business and assumed high debt levels, AEP's historic beta no longer capable to capture the substantial risks the company took on. Beta is also said to another troubling factor. This troubling factor is known to be a past price movement. It is stated that past price movements