Capital Asset Pricing Model and portfolio management
Following the development of portfolio theory by Markowitz, two major theories were put forth that employed the theory to derive a model for valuation of risky assets; they were namely the Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT).
Reilly and Brown (2000) defined Capital Asset Pricing Model (CAPM) as a model which indicated what the expected or required rates of return on risky assets should be. This model was a transition from the capital market line theory; it was vital to understand the transition because it helped to understand how to value an asset by providing an appropriate discount rate to use in the valuation model. Capital Asset Pricing Model has been widely used in the finance literature.
CAPM is derived from portfolio theory which applies statistical techniques to investment portfolio selection. The model uses the concept of capital market line to explain the required rates of return on risky assets.
A bigger problem to CAPM advocate was voiced by Roll (1976) who claimed that the market portfolio was not measurable and thus CAPM could never truly be tested. A possible deathblow to CAPM was FAMA-FRENCH (1992) that concluded when size and the market to book value are included in the model, Beta becomes insignificant. Finally the joint hypothesis problem is also a problem in the testing of any market model. This is the idea that a test is simultaneously testing both the market and the model. Because of these difficulties, we will never be able to say definitively whether CAPM is correct or not.
Roll criticised the usefulness of the model because of its dependence on a market portfolio of risky assets. He contended that such a portfolio was not currently available. He further highlighted that when CAPM is used to evaluate portfolio performance it is necessary to select a proxy for the market portfolio as a benchmark for performance. Following the above criticisms, an alternative asset pricing theory developed which was considered to be reasonably intuitive and required limited assumptions. Thus in the early 1970s Arbitrage Pricing Theory emerged which was developed by Ross as a response to the shortcomings of CAPM.
From the preceding paragraphs it can be concluded that CAPM has been an influential model in asset pricing theory as it has led the way to the development of other sophisticated multi-variate models like Arbitrage Pricing Theory. It would be fair to say that CAPM has laid the foundation to understand the asset returns better and had provided direction to understanding and analysing the theory on asset returns. Thus the contribution of CAPM to finance and portfolio management is rather significant.
Tags: arbitrage pricing theory, capital asset pricing model, capital asset pricing model capm, portfolio theory
