Contemporary asset pricing theories state that the decisive factor of a particular asset’s expected return depends on the non-diversifiable component of risk embodied within it. The main dilemma for asset pricing models simply boils down to the recognition and measurement of the relevant component in the firm-specific risk exercising influence on the expected returns. This essay will examine the recent theoretical developments in this area, focusing mainly on Sharpe and Lintner’s (1964a, 1965b) capital asset pricing model (CAPM). The aim of the essay is to question the validity of the CAPM by elucidating its theoretical and empirical flaws.
Description of the capital asset pricing model
Sharpe and Lintner’s (1964a, 1965b) CAPM is generally used in the estimation of (E) - the equity cost of capital (i.e. expected return on equity/assets).
E = Rf + β(ERP)
The risk-free rate (Rf) is a theoretical rate of return of an investment with zero associated risk (only in theory can risk be completely eradicated). The yield of index-linked government bonds provides a direct approximation of the risk-free rate used in CAPM formula. The beta variable (β) can briefly be described as the non-diversifiable firm-specific risk of the firm. The equity risk premium (ERP) represents the excess return that an individual stock or the whole stock market provides over a risk-free rate. The CAPM is equally applicable to the valuation of debt, for which the CAPM’s assumptions also are fulfilled. However, due to the efficient estimation of debt cost of capital through the comparable securities method the CAPM is rarely used for debt valuation (Chu, 2010). The CAPM is also used to estimate the asset-appropriate discount rate. In other words, the CAPM estimates the rate at which future cash flows generated by the asset should be discounted given the relative risk of the asset. Finally, it is also used to estimate the cost of capital that is to be used in the firm’s investment...