Study of The Capital Asset Pricing Model (CAPM) 02165 - Essay Example

The only condition followed in this case is the investor has to behave in conformity maintaining prescription of portfolio theory. Early practitioners are of opinion that beta is the only explanatory factor, which has the ability to explain cross-sectional variation in the asset prices. Therefore, the CAPM model has successfully examined the predictions, which are made for measuring the risk-return relationship of asset prices (Black, Jensen and Scholes, 1972). Though the model was initially developed by Harry Markowitz, it was later modified by Lintner and Sharpe.

The model actually explained that if a particular investor selects a portfolio for a period of time then he/she is said to be risk averse (Black, Jensen and Scholes, 1972). However, the modified version of the model is developed based on the following assumptions: CAPM has gained prominence in corporate finance, but there are many criticisms regarding its validity in the security market. The risk-return relationship is questioned, whether it has the ability to help the investor for making a good investment decision.

Sharpe (1964) and Lintner (1965) had identified the linear relation that exists between return, risk and beta of a stock. Beta is defined as a variable, which aims at explaining cross sectional returns of the stocks. The equation aims at explaining the risk-return relationship of the stocks to a great extent. The beta value is dependent on type of assets (Roll, 1977). It also helps in gauging the volatility of the stock with respect to market risk. The following interpretations can be made from the different value of beta (Solnik, 1974; Lahrech and Sylwester, 2011; Levy and Sarnat, 1970).

The above explanations indicates towards the fact that beta can easily establish the risk-return relationship of stocks. Therefore, it can be depicted that the CAPM is a perfect model for evaluating the debt and equity status of a company by examining its risk-rerun relationship of the