INVESTOR "RISK" (TOPIC)

When put into practice, the widely used capital asset pricing model (CAPM) has pros and cons.

CAPM Model: An Overview

The capital asset pricing model (CAPM) is a finance theory that establishes a linear relationship between the required return on investment and risk. The model is based on the relationship between an asset's beta, the risk-free rate (typically the Treasury bill rate), and the equity risk premium, or the expected return on the market minus the risk-free rate.

At the heart of the model are its underlying assumptions, which many criticize as unrealistic and might provide the basis for some of its significant drawbacks.1 No model is perfect, but each?should have?a few characteristics that make it practical and applicable.

Advantages of the CAPM Model

There are numerous advantages to the application of the CAPM, including:

Ease of Use

The CAPM?is a simple calculation that can be easily stress-tested to derive a range of possible outcomes to provide confidence around the required rates of return.

Diversified Portfolio

The assumption that investors hold a diversified portfolio, similar to the market portfolio, eliminates unsystematic (specific) risk.?

Systematic Risk

The CAPM?considers systematic risk (beta), which is left out of other return models, such as the dividend discount model (DDM). Systematic or market risk is an important variable because it is unforeseen and, for that reason, often cannot be completely mitigated.?

Business and Financial Risk Variability

When businesses investigate opportunities, if the business mix and financing differ from?the current company, other required return calculations, like the?weighted average cost of capital (WACC), cannot be used. However,?the CAPM can.

When used with other aspects of an investment mosaic, the CAPM can provide unparalleled yield data that can support or eliminate a potential investment.

Disadvantages of the CAPM Model

Like many scientific models, the CAPM has its drawbacks. The primary disadvantages are reflected in the model's inputs and assumptions, including:

Risk-Free Rate (Rf)

The commonly accepted rate used as the Rf?is the yield on short-term government securities. The issue with this input is that the yield changes daily, creating volatility.

Return on the Market (Rm)

The return on the market can be described as the?sum of the capital gains and dividends for the market. A problem arises when, at any given time, the market return can be harmful. As a result, a long-term market return is utilized to smooth the return. Another issue is that these returns are backward-looking and may not represent future market returns.?

Ability to Borrow at a Risk-Free Rate

CAPM?is built on four?significant assumptions, including one that reflects an unrealistic real-world picture. This assumption—investors can borrow and lend at risk-free rates—is unattainable. Individual investors cannot borrow (or lend)?at the same rate as the U.S. government. Therefore, the minimum required return line might be less steep (provide a lower return) than the model calculates.?

Determination of Project Proxy Beta

Businesses that use the CAPM to assess an investment must find a beta reflective of the project or investment. Often, a proxy beta is necessary. However, accurately determining how to evaluate the project properly is complex and can affect the reliability of the outcome.