Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 13

Criticism of CAPM and Beta versus Other Risk Measures¹

Introduction

CAPM Assumptions and Beta as a Risk Measure

Problems with CAPM Assumptions

Testing Asset Pricing Models

Testing Risk Factors Priced by the Market

Risk Measures beyond Beta

Total Risk

Adjusted Beta for Company Size and Company-specific Risk

Downside Risk

Value at Risk

Scenario-based Approach

Duration

Yield Spreads

Fundamental Risk

Summary

Appendix 13A: Example of Computing Downside Beta Estimates

INTRODUCTION

Even though the capital asset pricing model (CAPM) is the most widely used method of estimating the cost of equity capital, the accuracy and predictive power of beta as the sole measure of risk have increasingly come under attack. As a result, alternative measures of risk have been proposed and tested. That is, despite its wide adoption, academics and practitioners alike have questioned the usefulness of CAPM in accurately estimating the cost of equity capital and the use of beta as a reliable measure of risk.

While the CAPM explains how investors should act and price risk, empirical research has shown that investors often act differently than predicted by CAPM. This chapter explores these criticisms, alternative measures of risk, and the other methods used to estimate the cost of equity capital.

CAPM ASSUMPTIONS AND BETA AS A RISK MEASURE

Harry Markowitz, father of modern portfolio theory, organized the concepts and methodology of portfolio selection using statistical techniques.² His goal was ...