8-3 Validity and Role of CAPM

CAPM is the best model of risk-return we have. however it has it's quirks.

CAPM test.

The CAPM predicts that the risk premium should increase in proportion to beta.

critics of CAPM:

• the slope of the line has been mostly flat in recent years. low beta portfolio performance = high beta portfolio performance.
• capm predicts that beta is the only reason that expected returns differ.

Assumptions behind CAPM

• US treasury bills are risk free.
  • even if little chance of default
  • still not a guaranteed return because there may be inflation higher than than the return of bills.
• investors can borrow money at the same rate of interest at which they can lend.
  • generally borrowing rates are higher than lending.