Examining the Capital Asset Pricing Model (CAPM) in the Indian Capital Market

Some authors argue that not only the most discerning investor cannot establish the composition of the true market portfolio, but there is also no reason to assume that systematic risk is the sole factor affecting a security's expected return.

This study aims to examine whether the standard Capital Asset Pricing Model (CAPM) by Sharpe (1964) and Lintner (1965) holds in the Indian capital market.

Introducing the Topic and Key Assumptions

Chapter 1 introduces the topic, emphasizing the concept and importance of CAPM in the Indian context. The basic tenet of the CAPM model summarizes the following assumptions:

• Investors are risk-averse and prefer expected returns while avoiding risk.
• Investors base investment decisions on expected returns and the variances of security returns.
• Investors behave normatively and aim to hold a portfolio along the efficient frontier.
• A riskless asset exists, allowing investors to lend or invest at the riskless rate and borrow at this rate at any moment.
• All investments are perfectly divisible, meaning that every security and portfolio is equivalent to a mutual fund, and fractional shares can be purchased in any amount.
• All investors have homogeneous expectations regarding investment horizons, holding periods, forecasted expected returns, and risk levels on securities.

Reviewing the Literature and Methodological Issues

Chapter Two of this study reviews the literature on the CAPM model, dividing it into three broad headings:

• A. Methodological issues influencing empirical methods.

Exploring the Theory of CAPM

Chapter three of the study explores the Theory of CAPM. In finance, the Capital Asset Pricing Model (CAPM) determines a theoretically appropriate required rate of return for an asset, assuming it is added to a well-diversified portfolio. The model considers the asset's sensitivity to non-diversifiable risk, often represented by the quantity beta (β), the expected return of the market, and the expected return of a theoretical risk-free asset. CAPM suggests that an investor's cost of equity capital is determined by beta.

Despite its empirical shortcomings and the presence of more modern approaches to asset pricing and portfolio selection, such as arbitrage pricing theory and Merton's portfolio problem, the CAPM remains popular due to its simplicity and utility in various situations.