The Capital Asset Pricing Model

Risk has been a key consideration when dealing with assets since the 1960s (Shefrin and Statman, 2000). Several models have been developed to calculate risks, but CAPM has received the largest support among many financial experts. Like any other capital budgeting model, CAPM has its own weaknesses and strengths. In order to improve its usefulness, the standard capital asset pricing model has undergone various developments and modifications in the recent past.
Since its conception about four decades ago, the Capital Asset Pricing Model has been used widely in applications to estimate the cost of capital of firms and evaluate the performance of asset portfolios in companies. This report argues that CAPM has received such wide support and use in the industry despite its strong assumptions because it provides powerful and reliable predictions about risk measurements and the relationship between risk and expected return. CAPM has several problems which are considered by many as the results of theoretical failures emanating from the strong assumptions of the model (Rubinstein 2006). However, they could also be caused by the difficulties of its empirical implementation. Although these problems are common, it is also understood that other models have their problems too. Therefore, the best model is the one which has proved to be successful in its application. Capital Asset Pricing Model is the model with such wide and successful application because it provides powerful and reliable predictions about risk and returns of a given portfolio of assets.
The Capital Assets Pricing Model (CAPM) suggests that the equilibrium rates of return of risky assets in the market have a linear relationship with the market portfolio. CAPM is used to establish a theoretical value of the required rate of return of an asset in a diversified portfolio. This takes into consideration the systematic and market risks which are non-diversifiable risks (Rubinstein 2006).&nbsp.