Does The Capital Asset Pricing Model Work? [2 Answers Found]

 E R I = R f + β I ( E R m − R f ) where: E R I = expected return of investment R f = risk-free rate β I = beta of the investment ( E R m − R f ) = market risk premium begin &ER_i = R_f + beta_i ( ER_m – R_f ) \ &textbf \ &ER_i = text \ &R_f = text \ &beta_i = text \ &(ER_m – R_f) = text \ end ​ERi​=Rf​+βI​(ERm​−Rf​)where:ERi​=expected return of investmentRf​=risk-free rateβI​=beta of the investment(ERm​−Rf​)=market risk premium​ [1]
E ( r I ) = R f + β I ( E ( r m ) − R f ) where: E ( r I ) = return required on financial asset I R f = risk-free rate of return β I = beta value for financial asset I E ( r m ) = average return on the capital market begin&E(r_i)= R_f + beta_i(E(r_m)-R_f)\&textbf\&E(r_i)=text I\&R_f=text\&beta_i=texti\&E(r_m)=textend ​E(ri​)= Rf​ + βI​(E(rm​)−Rf​)where:E(ri​)=return required on financial asset iRf​=risk-free rate of returnβI​=beta value for financial asset iE(rm​)=average return on the capital market​ (edited by Merissa Brand on September 21, 2020) [2]
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Accaglobal.com goes on to mention that finding a value for the equity risk premium (ERP) is more difficult. The return on a stock market is the sum of the average capital gain and the average dividend yield. In the short term, a stock market can provide a negative rather than a positive return if the effect of falling share prices outweighs the dividend yield. It is therefore usual to use a long-term average value for the ERP, taken from empirical research, but it has been found that the ERP is not stable over time. In the UK, an ERP value of between 3.5% and 4.8% is currently seen as reasonable. However, uncertainty about the ERP value introduces uncertainty into the calculated value for the required return. [3]
With so many studies attacking the validity of CAPM, why in the world would it still be so widely recognized, studied and accepted? One explanation might be in the 2004 study conducted by Peter Chung, Herb Johnson and Michael Schill on Fama and French’s 1995 CAPM findings. They’re have finding that stocks with low price/book ratios are typically companies that have recently had some less-than-stellar results and may be temporarily out of favourr and low in price. On the flip side, those companies with higher than market price/book ratios might be temporarily pumped up in price because they are in a growth stage. (emended by Jessica H. From Al Mahallah Al Kubra, Egypt on August 17, 2021) [4]

Article References

  1. https://www.investopedia.com/terms/c/capm.asp
  2. https://www.investopedia.com/articles/investing/021015/advantages-and-disadvantages-capm-model.asp
  3. https://www.accaglobal.com/uk/en/student/exam-support-resources/fundamentals-exams-study-resources/f9/technical-articles/CAPM-theory.html
  4. https://www.investopedia.com/articles/financial-theory/09/capm-error-problem.asp
Mae Chow

Written by Mae Chow

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