The capital asset pricing model (CAPM) is a widely-used finance theory that

establishes a linear relationship between the required return on an investment

and risk. The model is based on the relationship between an asset's beta,
the risk-free rate(typically the Treasury bill rate) and the equity risk
premium (expected return on the market minus the risk-free rate).

At the heart of the model are its underlying assumptions, which many criticize as
being unrealistic and might provide the basis for some of the major drawbacks of
the model.
Drawbacks
Like many scientific models, the CAPM has its drawbacks. The primary
drawbacks are reflected in the model's inputs and assumptions.
Risk-free Rate (Rf): The commonly accepted rate used as the Rf is the yield
on short-term government securities. The issue with using this input is that
the yield changes daily, creating volatility.
Return on the Market (Rm): The return on the market can be described as
the sum of the capital gains and dividends for the market. A problem arises
when at any given time, the market return can be negative. As a result, a
long-term market return is utilized to smooth the return. Another issue is
that these returns are backward-looking and may not be representative of
future market returns.

 Ability to Borrow at a Risk-free Rate: CAPM is built on four major

assumptions, including one that reflects an unrealistic real-world picture.
This assumption, that investors can borrow and lend at a risk-free rate, is
unattainable in reality. Individual investors are unable to borrow (or lend) at
the rate the US government can borrow at. Therefore, the minimum
required return line might actually be less steep (provide a lower return)
than the model calculates.
Determination of Project Proxy Beta: Businesses that use CAPM to assess
an investment need to find a beta reflective to the project or investment.
Often a proxy beta is necessary. However, accurately determining one to
properly assess the project is difficult and can affect the reliability of the
outcome.

THE BEGINNINGS OF A MODEL

In tracing the origins of the CAPM, two
papers appear to have been the primary inspirations.
In 1952, Harry Markowitz provided the first truly
rigorous justification for selecting and diversifying a
portfolio with the publication of his paper Portfolio
Selection. Later, he would expand his meanvariance
analysis to a book-length study (1959)
which firmly established portfolio theory as one of
the pillars of financial economics. Markowitzs work
presents a direct and obvious root to the CAPM.
After publishing his initial paper, Markowitz became
interested in simplifying the portfolio selection
problem. His original mean-variance analysis
presented difficulties in implementation: to find a meanvariance efficient portfolio, one needs to

calculate the variance-covariance matrix with N(N1)/2 elements. Thus, a reasonably sized portfolio of
100 securities requires the daunting task calculating
4,950 variances or covariances. Markowitz
suggested a possible solution to this problem by
proposing a single index model (now referred to in
the literature as a one-factor model). Indeed, it was
this idea that involved William Sharpe with
Markowitz and put Sharpe on a line of research that
culminated in his version of CAPM.
The other paper which motivated
researchers is Franco Modigliani and Merton Millers
classic 1958 analysis, The Cost of Capital,
Corporation Finance, and the Theory of Investment.
In their original analysis, they explore the
connections between a firms capital structure and its
cost of capital or discount rate. The absence of a
theory for determining the correct discount rate
provided the impetus for Jack Treynor to develop the
first truly theoretical analysis for determining the
discount rate.