CAPM: Financial Theory and Criticisms
The Capital Asset Pricing Model (CAPM) is a financial theory that describes the relationship between risk and expected return for a given asset. According to the model, the expected return of an asset is equal to the risk-free rate of return plus a risk premium, which is based on the asset’s beta. Beta is a measure of the volatility of an asset relative to the overall market. One of the key assumptions of the CAPM is that investors are risk-averse and will only invest in an asset if they are compensated with a higher expected return. This means that investors will demand a higher return for assets that are more risky, as measured by their beta. One of the criticisms of the CAPM is that it relies on the assumption of efficient markets, which may not always hold true in practice (Fama, 2020). Additionally, the model has been found to be less accurate for assets with low betas or for assets in emerging markets (Chen, 2020). Cont…
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