Revolutionizing Finance And Management Research: Unveiling The Potential Solutions To The Capital Asset Pricing Model

Abstract

CAPM has been in existence for a long time as a basic theory in finance and is still applied today to explain the risk-return connection. Even though CAPM is a very useful tool for the estimation of the required rates of returns, it has some shortcomings due to the historical background and the assumptions made in the model such as the rationality of investors and the one-factor risk model that does not reflect the real market. This review article also assesses the CAPM and considers modern developments that seek to solve the model’s problems. Some of these developments are the Fama-French three-factor and five-factor models that add several factors of risk including size, value, profitability, and investment to explain returns on assets. The Arbitrage Pricing Theory (APT) improves the explanatory power of the multiple factors of risk. Also, the incorporation of Behavioral finance into the existing asset pricing models is another accomplishment that considers the psychological factors and the irrationality of the market. About the improvements offered by these models, this article also focuses on the application of finance and management. In these regards, the review demonstrates that the demand for a closer fit between theories of finance and the market also increases over time and enhances investment and risk. The implication of the study is therefore to support the argument that more theories in asset pricing need to be developed to fit the dynamic financial markets.