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Capital Asset Pricing Model
Finance & Accounting
Pages 4 (1004 words)
Discuss the main theoretical limitations of the CAPM. The Capital Asset Pricing Model (CAPM) is a model that shows the relationship between risk of an asset and its expected return. Its major limitations stem from its methodological assumptions. One of the assumptions it makes relates to the relative volatility of investment.
Usually, the overall volatility of the market is measures through proxies when implementing this model, for instance, the use of FTSE index. Such proxies are not usually the true measures of the market volatility which is at the core of the CAPM assumptions. Therefore, the model estimations from CAPM with use of market proxies for volatility can only predictions that are approximates and not the accurate measures of risk and return relationships. Another unrealistic assumption the CAPM model makes is the existence of a free risk security. In reality, there is not security that is free from risk. Usually, researchers use government security as a risk free security. The truth is while the government may not default (thus considered no risk), other factors such as inflation are uncertain and may impact on the real rate of return. There is also the assumption in the CAPM that the lending and borrowing rates are equal. In reality, this is incorrect as these rates usually differ. The model also makes an assumption that investors will hold highly diversified portfolios. This is not always the case as investors may not hold such highly diversified portfolios and therefore the entire market indices may not be well diversified. This therefor affects the results of CAPM model in estimating market returns. ...
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