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Capital Asset Pricing Model - Assignment Example

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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…
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Capital Asset Pricing Model

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. It is therefore unlikely, given these assumptions, that investors behaviour can be accurately explained by this model and also accurately measure the risk of investment. Another limitation of the CAPM model is that given the assumptions it makes, it is difficult to establish its practical validity as well as its empirical validity. Empirical results on whether there is a significant relationship between beta and expected return has been mixed. For instance, some studies have found positive but weak correlations. Others have revealed that returns were not only related to betas but also with other risks such as firm specific risks. Further, other studies find no relationship between beta and returns. Returns have also been found to be highly correlated with other factors such as size of the firms, market and book value ratios, among other factors. These call for need to establish whether beta can be used to measure the risk of securities and whether it is correlated with expected return. Without this, practical and empirical validity cannot be assumed. Another conceptual problem that is linked to validity is the fact that empirical studies on CAPM model have used actual past data and not expected prices to test the model. This introduces bias and there is need to use expected prices to test the model to examine its validity. Another assumption of capital asset pricing model is that betas are assumed to remain stable over time. This is not possible. From the model, beta is a measure of future risk of securities. Investors on the other hand only have past data of share prices and market portfolios, and not future data. Beta can therefore only be estimated from past data. When past data is used to measure beta, such beta can only be a reliable measure of future risk if it can remain stable over time. This is not possible as studies have found that individual securities do not remain stable over time. Therefore, historical betas are not good predictors of future risk of securities. Describe Roll’s critique of the early empirical tests of the CAPM. Roll has two issues with the CAPM model. The first criticism is stemmed from one of the ... Read More
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