A review of the theory of and evidence on the use of the capital asset pricing model to estimate expected share returns

Abstract

The underlying principle of the Capital Asset Pricing Model (CAPM) is that there is a linear relationship between systematic risk, as measured by beta, and expected share returns. The CAPM attempts to describe this relationship by using beta to explain the differences between the expected returns on various shares and share portfolios. The CAPM has been the subject of considerable theoretical investigation and empirical research. The aim of this article is to establish the current knowledge of the usefulness of the CAPM, i.e. whether it provides a reasonable description of reality and whether it is a useful tool for investment decision‐making. The main conclusion drawn from the study is that the CAPM is useful and that it does describe and explain the risk/return relationship. However, other risk factors (i.e. other than beta) may also be useful for explaining share returns. Investors should therefore be cautious when using the model to evaluate investment performance.