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Corporate Finance - Essay Example
The CAPM refers to a set of predictions concerning equilibrium expected returns on risky assets. The CAPM was developed twelve years following the foundations of modern portfolio theory laid down by Harry Markowitz. (Bodie et al., 2005). The CAPM was developed by William Sharpe, John Lintner and Jan Mossin…
Where represents the return on security I, is the return on a risk-free investment such as the Treasury bill or government bond is the sensitivity of the return on security I, to movements in the market portfolio, and is the expected return on the market portfolio. (Bodie et al., 2005).
The CAPM predicts that the expected excess return from holding an asset is proportional to the covariance of its return with the market portfolio (i.e., its beta) as shown in equation (1) above. (Merton, 1973). This implication of the CAPM has been contested by a number of researchers. For example, Black et al. (1972) provide evidence contrary to the above. They find that low beta stocks earn a higher return on average and high beta stocks earn a lower return on average than those predicted by the CAPM. This indicates that, there should be other variables that account for the return on an asset. Despite this criticism, Merton (1972) suggest that the CAPM is still useful because it is an equilibrium model which provide a strong specification of the relationship among asset yields that is easily interpreted although it fails to explain a significant fraction of the variation in asset returns. ...