The Righteousness of CAPM for Capturing Bankruptcy Risk

Abstract

The important risks that investors and corporate managers face are liquidity risk and bankruptcy risk. Capital Asset Pricing Model is one of the most applied methods developed for corporate managers to calculate the cost of equity and to examine risk-return relationship on financial securities, but it only considers systematic risk and ignores unsystematic risk under the assumption of diversification. Bankruptcy risk plays a key role in determining the cost of capital while investing in a specific firm; however, the current methodology of CAPM fails to capture bankruptcy risk, as it is mainly an unsystematic risk. This study highlighted the importance of making bankruptcy risk a part of total risk and investigate the validity of beta as per the current methodology of CAPM. Moreover, the study explored the possibility of replacing systematic risk and unsystematic risk with iquidity risk and bankruptcy risk. The results of the test to check validity of beta suggested that standard beta is unable to capture bankruptcy risk and results of Cumulative Risk Measurement test helped to identify the nature of risk i.e. liquidity risk or bankruptcy risk and the extent of these risks.