The widely used capital asset pricing model (CAPM)—when put into practice—has both pros𒁃 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 an investment and risk. The model is based on the relationship between an asset's beta, the 澳洲幸运5官方开奖结果体彩网:risk-free rate (typically the 澳洲幸运5官方开奖结果体彩网:Treasury bill rate), and the equity risk premium, ꦫor the expected return on the market minus the risk-free rate.

$\begin{aligned}&E(r_i)=\ R_f\ +\ \beta_i(E(r_m)-R_f)\\&\textbf{where:}\\&E(r_i)=\text{return required on financial asset } i\\&R_f=\text{risk-free rate of return}\\&\beta_i=\text{beta value for financial asset }i\\&E(r_m)=\text{average return on the capital market}\end{aligned}$​E(ri​)= Rf​ + βi​(E(rm​)−Rf​)where:E(ri​)=return r𒀰equired on financial asset iRf​=risk-free rate of returnβi​=beta value fo🎀r ꧒financial asset iE(rm​)=averag✤e return on the capi♌tal market​

At the 澳洲幸运5官方开奖结果体彩网:heart of the model are its underlying assumptions, which many criticize as being unrealistic and which might provide the basis for some of its major drawbacks. No model is perfec🌠t, but each should have a few characteristics that make it useful and appl⛄icable.

Advantages of the CAPM Model

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

Ease of Use

The 澳洲幸运5官方开奖结果体彩网:CAPM is a simple calculation that can be easily stress-tested to derive a range of p𒀰ossible outcomes to provide confidence around the require🍸d rates of return.

Diversified Portfolio

The assumption that investors hold a diversified portfolio, similar to the market portfolio, eliminates 澳洲幸运5官方开奖结果体彩网:unsystematic (specific) risk. 

Systematic Risk

The CAPM takes into account 澳洲幸运5官方开奖结果体彩网:systematic risk (beta), which is left out of other return models, such as the 澳洲幸运5官方开奖结果体彩网: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 business, then other required return calculations, like the 澳洲幸运5官方开奖结果体彩网:weighted average cost of capital (WACC), cannot be used. However,&💙nbsp;the CAPM♔ can.

Disadvantages of the CAPM Model

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

Risk-Free Rate (Rf)

The commonly accepted rate used as the R_f is the yield on short-term government securities. The issue with using this input is that the yield changes daily, creating 澳洲幸运5官方开奖结果体彩网:volatility.

Return on the Market (Rm)

The return on the market can be described as the sum of the 澳洲幸运5官方开奖结果体彩网:capital gains and dividends for the market. A problem arises when, at any given time, the market return can be negative. As a result, a long-term market return is utilized to smooth❀ the return. Another issue is that these returns are backwar𒊎d-looking and may not be representative of future market returns. 

Ability to Borrow at a Risk-Free Rate

CAPM is built on four major assumptions, including one that reflects an unrealistic real-world picture. This assumption—that investors can borrow and lend at a risk-free rate—is unattainable in reality. Individual investors are unable to borrow (or lend) at the same rate as the U.S. government. Therefore, the 澳洲幸运5官方开奖结果体彩网:minimum required return line might actually be less steep (provide a lower return) than the model calculates.&nb😼sp;

Determination of Project Proxy Beta

Businesses that use the CAPM to assess an investment need to find a beta reflective of the project or investment. Often, a proxy beta is necessary. However, a🙈ccurately determining one to properly assess the project is difficultꦬ and can affect the reliability of the outcome.