The Capital Asset Pricing Model - Essay Example

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. Unrealistic assumptions Based on the unrealistic assumptions, it is also hard to find a security that is risk free.

For example, while a highly liquid short term government security may be considered as risk free, it will be unlikely that the government will default on the security. This is because of the inflation rate which is another significant factor that will affect the portfolio’s returns. This is because; a portfolio’s variance or standard deviation is usually assumed to be an adequate measurement for a investment’s risk level, which is normally certified under the assumption of returns being normally distributed.

However, in practice, there are several other risk measures that will play an important role in the determination of an assets’ degree of risk (Pahl, 2009.p.345). The returns on assets, under the CAPM, are required to take the form of a normal distribution model. Consequently, the return on the assets in the real world may be non-normal and irregularly distributed. b. Difficulty in determining the model’s validity Additionally, it is difficult to assess the validity of the model in the testing of returns of assets.

This is because most of the model’s assumptions may not be critical as a result of the practical validity of the model. Consequently, this model recognizes that different investors have different abilities for investing hence; the cost of their investments will be largely expected to have an effect on the efficiency of the portfolio. Additionally, since the portfolio markets tend to be frictionless, it is likely expected that there would be no transaction costs, taxes and restrictions on the nature of trade offered.

However, theoretically, this act as a limitation for this model as frictionless markets may not be in existence in real practice. Consequently, while the model might assume that assets in the market are infinitely divisible to be held or traded on, the best option would be to have the market portfolio include all the opportunities of investment available in the market, and with a market value. As such, it is