The wid𒉰ely used capital asset pricing model (CAPM)—wh🍌en put into practice—has both 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 an investment and risk. The model is based on the relationship between an asset's beta, the 澳洲幸运5开奖号码历史查询:risk-free rate (typically the 澳洲幸运5开奖号码历史查询:Treasury bill rate)꧒, and the equity risk premium, or the expected return on the market minu꧒s 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&n🍃bsp;required on financia𝐆l asset iRf​=risk-free rate of returnβi​=be🀅ta value for financi𒐪al asset iE(rm​)=averag꧂e return&nb🎃sp;on the capital market​

At the 澳洲幸运5开奖号码历史查询: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 perfect, but each should have a few characteristics that makeဣ it useful and a🍌pplicable.

Advantages of the CAPM Model

There are numerous advantages to the ap♛plication of the CAPM, 🃏including:

Ease of Use

The 澳洲幸运5开奖号码历史查询:CAPM is a simple calculation that can be easily stress-tested t𝓡o de🐼rive 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 澳洲幸运5开奖号码历史查询:unsystematic (specific) risk. 

Systematic Risk

The CAPM takes into account 澳洲幸运5开奖号码历史查询:systematic risk (beta), which is left out of other return models, such as the 澳洲幸运5开奖号码历史查询:dividend discount model (DDM). Systematic or market risk is an imp✨ortant 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开奖号码历史查询:weighted average cost of capital (WACC), cannot be used.ꦬ💮 However, 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开奖号码历史查询:volatility.

Return on the Market (Rm)

The return on the market can be described as the sum of the 澳洲幸运5开奖号码历史查询: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 backward-looking and may not be representative of future market returns.&ꦕnbsp;

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开奖号码历史查询:minimum required return line might actually 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 need to find a beta reflective of the project or investment. Often, a proxy beta is necessary. However, accurately determining one to properly assess the project is difficult and can affect the relia🌠bility of the outcome.