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. 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 ...
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(Capital Asset Pricing Model Assignment Example | Topics and Well Written Essays - 1000 Words)
“Capital Asset Pricing Model Assignment Example | Topics and Well Written Essays - 1000 Words”, n.d. https://studentshare.net/finance-accounting/110849-capital-asset-pricing-model.
There is a famous saying that one should not place all the eggs in one basket. The concept of portfolio also came from this saying which means that one should not make all the investment in one asset or security and should diversify the investment by investing in a group of assets so that the loss from one security can be compensated by the gain of the other security.
This paper will outline how this method of valuing an asset fits to be a factor pricing model. This will entail discussing the assumptions relating to the form of stochastic discount model as well as how the factor method is related to the acquiring of equilibrium risk premium.
One of the limitations of the model is that the investors are solely interested in the return of the investment and the rate at which the investment gives return whereas it is not the case. Investors invest in the securities so as to earn profit which shall be either in the case of interest that the security gives upon the investment or by means of capital gain that when the price of the security gets high then the investor sells the investment and earn a capital gain.
The idea of investing in the financial market is to purchase the asset while the price is low, and to sell when the price appreciates.
The seeming arbitrary movement of prices of assets, such as stocks, has
stment in one asset or security and should diversify the investment by investing in a group of assets so that the loss from one security can be compensated by the gain of the other security. The gain achieved from one asset can offset the loss incurred from the other only if
This model considers systematic risks, this are the risks that are do occur on daily basis and are normally referred to as unknown risks. This is a reality since, investors will never invest to any business that he/she has doubt that returns from his
The risk free rate is the government bond ideally, that has a fix ten years. The Beta is the true measure of the risk that is in the stock that one has invested on.
With the risk in it, measure the volatility of the investment. It is in this
To start with, we will understand the concept of an efficient portfolio as described below.
Most investors, according to mean-variance analysis and asset pricing model, tend to invest in a more efficient portfolio
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