Flaws in the Capital Asset Pricing Model

The relationship between risk and return is primary in corporate finance. The fundamental notion is that investors are generally risk-averse. Regardless if the risk of an asset is measured on a stand-alone basis or in a portfolio context, an asset with a higher degree of relevant market risk must provide investors with a relatively higher return on investment to intrigue them undertake the investment. Investors are willing to undertake a higher investment risk only if they expect to receive higher returns.

Modern portfolio theory holds that investors need to diversify their portfolio to eliminate unsystematic risk ("the risk that is inherent in each investment"). However, they also need to be compensated for the time they spend waiting to be rewarded for their investment. In other words, investors need to be compensated for the risk they undertake and for the time value of money invested.

The capital asset pricing model (CAPM) explains the relationship between risk and return by taking into consideration both factors, namely the time value of money and risk. In CAPM, the risk free rate (r) stands for the time value of money, while the beta (b) of each individual security stands for the risk undertaken. If risk is measured on a stand-alone basis, the beta compares the returns of an individual asset to the market (security beta). If risk is measured in a portfolio context, the beta compares the returns of the portfolio to the market (portfolio beta). In both cases, the risk that remains after diversification is market risk, which is measured by the extent to which a given security tends to fluctuate with the market.

CAPM is widely implemented because it has several advantages compared to other models of describing the relationship between risk and return including the Arbitrage pricing model (ATP) and the Three-Factor Model. By considering only systematic risk, it allows investors to eliminate unsystematic risk through portfolio diversification (modern portfolio theory). Besides, by investigating the relationship between systematic risk and expected return based on empirical research, it provides straightforward evidence on this relationship.

On the other hand, several concerns have been raised about the validity of CAPM.

One of the major flaws of CAPM is the use of variables. Analysts may use the short-term government debt as a substitute for the risk free rate (r). However, this is not a fixed variable, but subject to the daily changes of the broader economic environment. Another variable that causes uncertainly is the equity risk premium (ERP). ERP is not a fixed variable either and this causes uncertainty to the calculation of the expected return.

Perhaps the biggest problem with the CAPM is its use in calculating a discount rate. The problem arises in finding appropriate betas because typically most of the companies undertake several business activities. To ensure that the beta used is suitable, it has to be the weighted average of the betas of the numerous different areas of business activity. The weighted average is calculated based on the relative share of the company market value generated by each business activity. Yet, the problem is that information about relative shares may not be so easy to obtain.

Besides, although betas are publicly available, their value is not constant but changes based on the market risk and volatility. Also, betas are preferably used for short-term calculations rather than long-term because they are more likely to give an insight in the stock volatility to market fluctuations and interest rates changes over the short-term.

Finally, problems arise also when CAPM has to take into account different sources of financing. Companies with complex capital structures do not make known all their sources of financing, leading analysts to the assumption that the beta of the company equals zero. However, this oversimplification leads to inaccurate calculations in regards to discount rate.

Sources:

http://www.investopedia.com/terms/u/unsystematicrisk.asp

http://www.investopedia.com/terms/c/capm.asp

Brigham, E.F., Ehrhardt, M.C. (2005), Financial Management: Theory and Practice, 11^th edition.