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The Capital Asset Pricing Model

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Finance & Accounting

Pages 4 (1004 words)

The Capital Assets Pricing Model Name: Institution: Tutor: Course: Date: Question 1: The main theoretical limitations of CAPM The Capital Asset Pricing Model (CAPM) is an indicative mathematical model for the relationship that exists between the expected risk of an asset and the asset’s risk…

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## Introduction

The equation that is applied in the calculation of CAPM for the assets is as follows: E(Ri) =RF +?i [E(RM) - RF] Where, E (Ri) = expected return of the ith level. Rf = risk-free return of an asset (such as short-term government securities), ?i = beta coefficient of ith level, and (RM) = Expected return on the market. The main aim of the CAPM model underlies the identification of the market portfolio as the tangency portfolio between supply and demand in balance. However, there are several theoretical limitations that have hindered the operations of the model, in the manner that these limitations will likely cause deviations in the process of applying the model particularly between the reality and the model. These limitations can be broadly classified as: a. Being based entirely on unrealistic assumptions. b. Testing the model’s validity is quite difficult. c. Its betas will not remain stable over a long duration of time. Based on these limitations, the model is accepted to having been based on several assumptions most of which are not realistic. The CAPM model supposes that the investors are always risk-averse hence, are most likely to select the investment portfolios that are efficient, and which will be based on the standard deviation or variance and expected returns of the returns from the assets (Whitman & Diz, 2013.p.85). a. ...

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