Validity of the CAPM
The capital asset pricing model is a rigorously derived equilibrium model. Like any other economic model, it is an abstraction and simplification of reality. It has been widely used and hailed. Its popularity may be ascribed to a set of four factors. First, the risk-return trade-off-s-the direct proportional relationship between the two-has a distinct -intuitive appeal. Second, transition from the capital market line (CML) to the security market line (SML) shows that the unverifiable nature of the systematic risk makes it the relevant risk for pricing of securities and portfolios. Third, beta. the measure of systematic risk, is easy to compute and use. Finally, the model shows that investors are content to put their money in a limited number of portfolios. namely, a risk-free asset like Treasury bills and a risky asset like a market index fund.
However. CAPM is beset with a number of problems. One of these relates to the maturity of the risk-free asset, namely, interest rate-on a short-term government security like a T·bill or a long-term rate like that on a treasury bond or an intermediate term-rate like that on a 3 year treasury securities. The second problem relates to whether the market premium should be the expected or historical. Yet another problem relates to the use of an appropriate market index. The faulty use of a market index in likely to result: in faulty measurement of security measurement. Finally, there is the question if beta is the appropriate risk measure. To provide a solution to these challenges, an extended CAPM and alternative models have emerged. These models incorporate multiple variables and factors. They are briefly discussed in the next Section.