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Finance & Accounting
Pages 4 (1004 words)
Capital Asset Pricing Model (CAPM) Name Course Professor Institution City and State Date Capital Asset Pricing Model (CAPM) CAPM is a financial theory that aims at calculating the yields of a stock while taking into consideration the risk of the asset. The hypothesis argues that the expected return on an asset is linearly related to the systematic risk and the risk free rate of return, multiplied by the hazardous premium (Ma, 2011).
CAPM has theoretical limitation, which include impractical assumptions and instability of the beta values. The Arbitrage Pricing Model and Rolls have criticized the theory indicating that it may be unreliable and invalid. This study will examine the theoretical limitations and criticisms of the theory. Theoretical Limitations of the Theory The theory argues that all investors are risk avoiders and that the returns are normally distributed (Ma, 2011). This is not the case because investors are normally risk takers who are willing to make huge returns when their predictions favor them and lose when they fail. Assuming that returns are normally distributed is also unfounded because investors are not usually sure of the yields on their assets (Ma, 2011). The assumption that assets are free from risk is also unrealistic because it is hard to find such stocks in the real world. The theory argues that short-term securities offered by the government are free from hazards because the state assures investors certain returns on the assets. This is not the case because the risk on the assets is in the form of inflation, which is the instability of prices in the market (Ma, 2011). ...
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