Question two
The application of the CAPM in modern financial markets has been much debated and criticized from an empirical point of view. Does this imply that the theory underlying CAPM is flawed? Outline your argument. Should we reject the model outright? If you think that the model should be rejected, provide alternative model(s) to replace it with empirical studies to support your choice. Otherwise, provide the reasons why CAPM should be kept.
The essay will argue that the numerous empirical evidence produced against CAPM model which are based on returns on stock does not invalidate the use of CAPM model in the estimation of cost of capital for projects in the decisions of capital budgeting. According to Harrington (2003), stocks are backed by the projects existing and the option of modifying the current projects and even undertake the new ones. However, the expected stock returns need to satisfy the CAPM even if the returns on projects expected do. According to Sincere (2004), CAPM model presents a theory that is simple and also delivers simple results. The theory states that the sole reason an investor, on average, should earn more by making an investment in a particular stock than the other is because a particular stock is riskier.
Hassett (2011) pointed out a study by Professor Kenneth and Eugene on the return on shares on the New York stock Exchange, Nasdaq and the American Stock Exchange between 1963 and 1993. The study revealed that the over a lengthy period, differences in beta did not explain different stocks performance. Moreover, the linear relationship between individual stock returns and beta over a short period of time also breaks down. As much as the findings may suggest that CAPM has some errors or is wrong, in the investment community the model is still widely used. Despite the fact that from beta, it is hard to make predictions on the