Financial Management

III YEAR Semester - V (2021-2026)

1st-Internal Assessment

Financial Management: Research Article

“A Critical Examination of
the Capital Asset Pricing Model (CAPM)”

NAME: Ananya Ahuja DIVISION: A

PRN: 21010126010 COURSE: B.B.A. LL.B.

(H)

BATCH: 2021-2026

WORD COUNT: 2000 (excluding footnotes)

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DATE OF SUBMISSION: 21th August 2023

INTRODUCTION

A frequently used paradigm for comprehending the price of financial assets, notably publicly
traded equities, is the Capital Asset price Model (CAPM). Its roots may be found in models
that deal with capital asset pricing under uncertainty and make the assumption that investors
tend to exhibit risk aversion, hence necessitating bigger returns in order to compensate for
assuming greater levels of risk. The rational expectations hypothesis states that rational actors
would make decisions based on an objective probability rule that measures the correlation
between risk and reward. The CAPM is in line with this assumption.

Investors who take on more risk are rewarded with better profits in efficient markets. It's
common to refer to this connection as the "first law of finance." A condensed version of the
argument was made by the U.S. Supreme Court, which claimed that the less risk there was,
the less reason there was to anticipate extraordinary returns on investments.

This article covers the Treynor and Sharpe ratios as well as how the CAPM, the cornerstone
of contemporary portfolio theory, was derived from mean-variance optimization.
Additionally, it highlights the importance of beta, a crucial element in several CAPM
versions. The article compares the CAPM with asset pricing theories that discriminate
between measurable risk and total uncertainty and explores the model's practical uses,
drawbacks, and expansions. The CAPM is still used in finance theory and practice today
despite empirical difficulties.

 Definition:
In the field of financial risk management, the Capital Asset Pricing Model (CAPM)
has an important place. Through mean-variance analysis, it offers a formal framework
for maximizing a portfolio's risk and return while taking into account the addition of a
risk-free asset like short-term government bonds. Fundamentally, CAPM estimates
the value of financial assets by accounting for the premium that investors need as
payment for taking on more risk.
 Methodology:

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Utilising a qualitative methodology and literature analysis, this study analyses the
performance of the Indian ombudsman using secondary materials such research
papers, journals, and books.

 Research Objectives:
This study's main goal is to critically assess the Capital Asset Pricing Model's
(CAPM) continued applicability and potential drawbacks in the setting of current
financial markets, with an emphasis on the Indian financial system. By taking into
account elements other than beta that multifactor models bring as well as the
application of alternative risk-free rates, this inquiry seeks to evaluate the model's
capacity to explain asset price patterns. The research will also look at behavioral
elements in an effort to identify and evaluate the impact of investor heterogeneity on
asset pricing. The goal of the study is to further our knowledge of the CAPM's
applicability and flexibility in various financial settings.

LITERATURE REVIEW

The Capital Asset Pricing Model (CAPM) has been vital to financial theory and asset pricing.
Its foundations rest on the premise that a well-diversified portfolio can be evaluated in terms
of its risk and return solely through the systematic risk, represented by beta. However,
extensive research has sought to evaluate the model's validity and relevance in the context of
evolving financial markets.

Early empirical studies by Sharpe (1964) 1, Lintner (1965)2, and Mossin (1966)3 supported the
CAPM, providing substantial evidence that market risk, as captured by beta, is indeed a
significant determinant of asset returns. These pioneering studies laid the groundwork for the
model's acceptance.

1
Sharpe, W.F. Capital asset prices: A theory of market equilibrium under conditions of risk. J. Financ. 1964, 19,
425–442.
2
Lintner, J. The valuation of risk assets and the selection of risky investments in stock portfolios and capital
budgets. Rev. Econ. Stat. 1965, 47, 13–37.
3
Perold, A. F. (2004). The Capital Asset Pricing Model. The Journal of Economic Perspectives, 18(3), 3–24.
http://www.jstor.org/stable/3216804

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Yet, over time, numerous challenges have been raised. Fama and French (1992) 4 introduced a
multifactor model that included size and value factors, contending that these factors, in
conjunction with beta, better explain asset returns. Subsequent research by Fama and French
(2015)5 extended the multifactor approach, further questioning the sufficiency of the CAPM
in accounting for market anomalies.

Recent research, including that by Blitz and Vidojevic (2019) 6, has delved into the
application of CAPM in emerging markets, particularly in India. They highlight the
significance of adjustments for market conditions specific to India and the implications for
the CAPM.

In summary, while the CAPM has long served as a foundational framework in financial
economics, ongoing research and evolving empirical evidence have challenged its
completeness. The multifactor models introduced by Fama and French and considerations of
risk-free rate variations underscore the need for a nuanced approach to asset pricing.
Furthermore, the application of the CAPM in emerging markets, as exemplified by studies on
India, underscores the importance of contextual adaptation and further research into its
appropriateness in various market conditions.

APPLICATIONS OF CAPM

The broad applicability of CAPM encompasses both individual stocks and portfolios,
providing a variety of useful applications. Governmental agencies, businesses, investors, and
portfolio managers may all benefit from CAPM.

 The Regulatory CAPM:

Regulatory situations are when the CAPM is used in a legally important way. The
CAPM is used by regulators to calculate the cost of capital for utility firms that are
owned by shareholders. For instance, when determining the cost of equity for water
and wastewater utilities, the Florida Public Service Commission uses a regulatory
form of the CAPM customized to utility-specific concerns.
4
Fama, E.F.; French, K.R. Size, value, and momentum in international stock returns. J. Financ. Econ. 2012,
105, 457–472.
5
Fama, E.F.; French, K.R. Size, value, and momentum in international stock returns. J. Financ. Econ. 2012,
105, 457–472.
6
Blitz, David and Hanauer, Matthias Xaver and Vidojevic, Milan and van Vliet, Pim, Five Concerns with the
Five-Factor Model (November 1, 2016). Available at
SSRN: https://ssrn.com/abstract=2862317 or http://dx.doi.org/10.2139/ssrn.2862317

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ru = rf + βu ( rm − rf )
In this variant, denoted by the subscript 'u,' the CAPM not only signifies the rate of
return necessary to attract investors (ru) but also quantifies the risk carried by
comparable firms involved in water and wastewater transport (βu). This dual
functionality of the regulatory CAPM is evident in its ability to gauge both firm-
specific and market-wide risk and return, aligning with the legal requirements
concerning firm revenue and investor compensation.
 Measuring Portfolio and Managerial Performance:
 The Sharpe Ratio, presents a commonly used application that immediately
derives from the mean-variance optimization of the risky tangent portfolio in
the CAPM. It determines how closely a stock portfolio's returns resemble a
large index, such the S&P 500, and hence reveals the equity risk premium.
The Sharpe Ratio is also a well-liked performance metric in active portfolio
management. It's interesting that it assesses both the manager's and the
portfolio's performance. Contrary to popular belief, William Sharpe, the
inventor of the Sharpe Ratio, favored passive indexing over active
management.
 Jensen's Alpha, a byproduct of the beta-specified CAPM, provides a more
accurate indicator of the efficiency of portfolio management. For actively
managed portfolios, it results from time-series return regression, producing an
intercept term and an error term denoted by the subscript.

rπ − rf = απ + βπ ( rm − rf ) + επ

This formula maintains a linear structure in accordance with the CAPM. The
Sharpe Ratio is a famous application of the CAPM, which has its roots in
mean-variance optimization of the hazardous tangent portfolio. The Sharpe
Ratio measures how closely a stock portfolio's returns resemble those of a
large index like the S&P 500, revealing the equity risk premium.
 Asset Allocation and Financial Planning:
 Bond Allocations, CAPM programs that analyze investment portfolios and
manager performance, are relevant to both individual and institutional
investors. Risk-averse individuals are often encouraged to incorporate bonds
in their portfolios by conventional financial advice. The separation theorem,

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which states that all investors should keep the same risky portfolio and utilize
cash or borrowing at the risk-free rate to manage risk, is considered by some
as being in opposition with this counsel.
To be fair, a portion of investment advice that is inspired by the CAPM and its
theoretical underpinnings recommends selecting struggling businesses as
prospective investment opportunities. Following this advice when creating a
portfolio raises the risk of the portfolio while also maximizing the advantages
of efficient diversification.

CRITISISMS OF CAPM

Science historians and philosophers have sometimes made the cynical claim that a scientist's
stature may be gauged by the degree to which they obstruct advancement in their profession.
According to this standard, the Capital Asset Pricing Model (CAPM) is one of the most
significant contributions to the field of financial economics. It's interesting to note that efforts
to question and refute the CAPM have given rise to important advancements in this field.

Two main categories may be used to group CAPM criticisms. The first class deals with
empirical findings of anomalies in asset price that cannot be sufficiently explained by beta
alone. As a result of these findings, multifactor alternatives to the CAPM have been created,
and categorical exceptions—particularly those relating to the factors value, scale, and
momentum—have filled what some have dubbed the "factor zoo."

While using quantitative techniques to solve the shortcomings of the conventional CAPM,
the second class of critiques maintains the mathematical underpinnings of the mean-variance
framework. Higher-moment CAPM is a good example of this strategy.

In addition to extending the CAPM to take into account larger statistical moments, different
extensions also call into question a number of the model's core presumptions. Early detractors
looked at the CAPM's geographical and temporal limitations. This strategy is shown by
extensions such the intertemporal CAPM, consumption-based CAPM, and evolving CAPM.
Multifractal models with roots in econophysics and complexity theory have also emerged as a
result of attention to the informational and behavioral variety among investors.

 Value, Size, and Momentum: The “Factor Zoo”:

The search for asset pricing factors beyond beta can be traced back to Fama and
MacBeth's extension of Jensen's interpretation of the CAPM as a time-series
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regression.7 These variables highlight elements not taken into consideration by the
conventional CAPM in their analysis if extra variables put in the cross-section of
returns create slopes that are statistically different from beta. Squared market betas,
which Fama and MacBeth included as a second variable, did not demonstrate a
nonlinear link between beta and predicted returns. They also failed to uncover any
indication of heteroskedasticity in residual variances, which would have shown the
existence of predictive factors other than beta.
Factor-based models should be seen as an addition to or development of traditional
asset pricing theories. However many variables are included in the "factor zoo," beta
and the original CAPM are still a good "first approximation" for market returns in
equilibrium.8 Therefore, the factor zoo should not be regarded as a comprehensive
replacement for the CAPM.
 Modeling Heterogeneous Agents:
 Transitioning from Homogeneity to Heterodoxy:
The efficient market hypothesis and the conventional CAPM are
fundamentally connected, but this connection is severed by the conventional
CAPM's rejection of the premise of a homogeneous market filled by
completely rational actors. As investor heterogeneity is included into asset
pricing, this deviation from homogeneity has given birth to a wide variety of
hypotheses.
The inclusion of investor heterogeneity supports certain features of asset
pricing orthodoxy while easing one of the standard CAPM's assumptions, all
the while encouraging theoretical creativity. For instance, segmenting a
market according to traders' preferred theories of welfare maximization, such
as cumulative prospect theory and anticipated utility 9, still preserves the
Security Market Line, a prominent feature of the traditional CAPM.
 Behavioral Capital Asset Pricing: A behavioral CAPM may take into
account a broad range of variables, such as fluctuations in stock market
participation, market segmentation based on various utility definitions, and
evolutionary asset pricing theory. The difference between knowledgeable

7
Fama, E.F.; MacBeth, J.D. Risk, return, and equilibrium: Empirical tests. J. Political Econ. 1973, 81, 607–636
8
Merton, R.C. On estimating the expected return on the market: An exploratory investigation. J. Financ. Econ.
1980, 8, 323–361.
9
Tversky, A.; Kahneman, D. Advances in prospect theory: Cumulative representation of uncertainty. J. Risk
Uncertain. 1992, 5, 297–323

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traders and "noise traders," which is a general term for people engaging in
transactions that are not solely motivated by rationality, gives rise to
behavioral finance theories.10. Empirical challenges persist in identifying these
differences, moving from the idea of separating rational information traders
from more reactive trend followers11 to devising and conducting empirical
tests to detect such heterogeneity. The finding of power law behavior in
markets connects multifractality and the fractal market hypothesis with
behavioral views on evolutionary asset pricing and segmented markets. The
next section discusses this crucial component of the Capital Asset Pricing
Model's continual development.

CONCLUSION & RECOMMENDATIONS:

Conclusion: In conclusion, the Capital Asset Pricing Model (CAPM) remains a central and
enduring framework in financial management, demonstrating its continued relevance today.
Originally conceived as a means to determine asset pricing and manage risk, the CAPM has
transcended its foundational principles. It is integral in guiding investment decisions,
particularly in the Indian financial landscape.

In India, where economic dynamics and market behaviors are unique, the CAPM's
adaptability and utility cannot be understated. Its applications in portfolio management,
regulatory assessments, and performance evaluation highlight its practical significance.
However, it is essential to acknowledge the evolving landscape of financial management and
continue to explore the model's limitations and extensions. As financial management in India
matures, the CAPM's enduring legacy lies in its ability to provide valuable insights into risk-
return dynamics, thereby facilitating more informed investment decisions and regulatory
assessments, and thereby contributing to the efficient functioning of the financial market.

Recommendations: In light of the research on the Capital Asset Pricing Model (CAPM),
several recommendations emerge. Firstly, future research should focus on refining the
model's applicability to unique market conditions, such as those prevalent in the Indian
financial landscape. Secondly, exploring alternative factors beyond beta to improve the
10
Black, F. Noise. J. Financ. 1986, 41, 529–543.
11
Chiarella, C.; Dieci, R.; He, X.-Z.; Li, K. An evolutionary CAPM under heterogeneous beliefs. Ann. Financ.
2013, 9, 185–215.

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CAPM's explanatory power is essential. Additionally, a continued examination of behavioral

aspects, as seen in multifactor models, will deepen our understanding of asset pricing.
Furthermore, empirical testing should persist, particularly regarding power law behaviors and
multifractality in market dynamics. Lastly, researchers should consider the dynamic evolution
of financial management and the ongoing relevance of the CAPM within an ever-changing
financial landscape.12

BIBLIOGRAPHY

Journals & Articles:

1. Khalife Soltani, A., eslamzade, O., & Nooryan, S. (2010). Capital Asset Pricing
Model & Adjusted Capital Asset Pricing Model. SSRN Electronic Journal.
https://doi.org/10.2139/ssrn.1577006
2. Capital Asset Pricing Model (CAPM) Versus FF Three Factor Model: The Choice of
Asset Pricing Model for Bank Stocks at Nairobi Securities Exchange. (2022).
American Research Journal of Business and Management, 8(1).
https://doi.org/10.21694/220012
3. Andrews, V. L. (1981). The Early History of “Financial Management.” Financial
Management, 10(2), 112. https://doi.org/10.2307/3665436
4. Sumeet, M. (2015, September 2). Financial Inclusion In India. International Journal
of Scientific Research and Management. https://doi.org/10.18535/ijsrm/v3i8.14
5. Yazlyuk, B., Guley, A., Brukhanskyi, R., Shovkoplias, H., & Shvydka, T. (2018,
March 30). Basic principles of financial markets regulation and legal aspects of the
legislative requirements. Investment Management and Financial Innovations, 15(1),
337–349. https://doi.org/10.21511/imfi.15(1).2018.28

12
Chan, L.K.C.; Lakonishok, J. Are reports of beta’s death premature? J. Portf. Manag. 1993, 19, 51–62.

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