Finance is very essential sector in all kind of organization to be successful. It contains many financial theories which have been developed throw the years depends on special circumstances such as time, money, demand and supply. One of the important financial theories' is the capital asset pricing model which gives the investor individuals or companies the ability to be more realistic in their investments by taking market risk into consideration. This paper will explain what the capital asset pricing model is, then it will descript the CAPM theoretical underpinning and it will conclude with evaluating the CAPM.
First of all, to have a good explanation of the theory, the historical background must be explained. The capital asset pricing model is a development theory of Markowitz's portfolio theory. Markowitz's portfolio theory was found in 1952 and awarded Nobel Prize in economics in 1990 (Watson & Head, 2006). The theory is giving the investors the ability to avoid desultory risk by choosing variety of portfolios which contain different number of shears. Markowitz's first point is to build the envelope curve which is giving the maximum return or minimum risk for a giving stage of return, this shows the investors a group of portfolio available choices when investing in a set of risky assets and it is advising the investors to invest in particular portfolio (Watson & Head, 2006).
However the portfolio theory has many problems with the practical application such as: the ability of investors to borrow at risk-free rate it is unrealistic, the theory has a problem in identifying the market portfolio and after identifying the make-up of the market portfolio it is expensive to be built because of the transaction cost which is unaffordable for smaller investors (Watson & Head, 2006).
In 1964 William Sharpe a PhD student supervised by Markowitz's developed the portfolio theory to find the capital asset pricing model theory by building a market balance theory of asset prices under regulations of risk. The new theory was also awarded Nobel Prize in economics in 1990 (Watson & Head, 2006). The capital asset pricing model is locating the fair price by using the market risk to avoid the influence of unsystematic risk. In spite of the capital asset pricing model is a development of the portfolio theory; there are many differences between them (Watson & Head, 2006). For example, in portfolio theory the unsystematic risk-free rate is used, where in the capital asset pricing model is being more realistic by using the systematic risk-free rate.
According to Watson & Head (2006), the capital asset pricing model based on many assumptions. First, investors are logical. Thus, they don’t want to take risk, they want to reach the maximum level of profit. Second, investors have the ability to get all the necessary information. Third, investors have the ability to lend and barrow at the risk-free rate. Forth, investors can hold...