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Financial Economics

In order to apply the capital asset pricing model it is assumed that the investors are rational whereas the investors are not rational and all the investors does not have same information. There are cases in which the investors gets an inside information related to a certain investment and thus invests in that investment. One of the major limitation is that the investors can borrow or lend any amount for any period of time at the risk free rate which is not possible in practice as there are limitations and restrictions and it is difficult to determine the risk free rate for a long period of time as it is considered as the rate of the government securities which are considered to be least risky. Capital asset pricing model considers the assets to be perfectly divisible and is marketable which is not possible in all circumstances as there are not sudden markets available for all of the assets and securities and all the assets are not perfectly divisible. Capital asset pricing model considers that no transaction cost is incurred in the purchase and sale of the securities and thus limits the practical implication in which the transaction costs are bared by investors when buying or selling the securities (Fama & French, 2004). Task A (b) The lending and the borrowing rate is elaborated as in the Role’s Critique of the empirical tests of capital asset pricing model they explained that risk free rate is available when lending is done but this rate is not available when it comes to borrowing. Thus the limitation of capital asset pricing model is further elaborated regarding the risking free rate as the risk free rate is only available for lending as the government securities can be bought which is easy but the risk free rate cannot be charged when borrowing as it is not possible (Ansari, 2000). Roll’s critique determined the limitation of the possibility regarding the selection of market portfolio where the relation is to be determine between the systematic risk and expected return on security is to be linear and if that is not the case than the efficiency is not determined of the capital asset pricing model but it is of the chosen index and the linear relation can be determined from any portfolio and not just from the market portfolio. The empirical test of capital asset pricing model is just the efficiency of the chosen market index and thus the relation is just the linear function of measured betas and of the average returns. Roll elaborated that the true market portfolio is necessary so as to test the efficiency of capital asset pricing model where all the conditions of capital asset pricing model are satisfied but the determination of the true market is impossible thus removing the possibility of testing the capital asset pricing model. Task A (c) The arbitrage pricing theory determined that the expected return is not only the basis of the expected return on which the investors make the investment decisions. The decisions of the investment regarding the investment is not assumed to be based solely upon the expected return which is the limitation of the capital asset pricing model and thus addressing and eliminating the limitation of capital asset pricing model. Capital asset pricing model’s limitation of the normal distribution of the return is accounting for in the
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