The market indices of the securities market may not always diversify well. The capital-pricing model will not explain investors’ behavior and the beta might fail in capturing the risk of investment in real life practice due to these factors. Therefore, the model fails to act as a uniform and efficient valuation model in a real practical situation. The model only works in a generalized situation that is when dealing with a portfolio but fail if the investment is broken down into single forms of securities. The capital asset pricing model assumes that the higher the risks the higher the return and that all the investors are risk averse. The model assumes that securities are highly divisible into small parts. The model further, assumes that all investors access information at the same time and that investors make decisions based on a single period horizon. The capital asset pricing model is practically difficult to validate. Empirical validation of the capital asset pricing model has to establish that beta has ability to measure the risk of a security (Szyszka, 2009). It also has to show that there is a significant correlation between beta and the expected rate of return. The empirical results have however, being of mixed outcomes. The results have shown that the relationship is not as strong as the capital asset pricing model indicates. The results also have also shown that the expected returns are also related to other measures of risk, which includes firm’s specific risk. Other factors such as market value and book value ratios relationship with returns were found to be significant. In order to test capital asset pricing model empirically researchers need to use data on expected prices. However, the data available is historical information only. This therefore, will result to biased empirical results. The capital asset pricing model assumes that the market portfolio consists of all the assets in all the markets. The market portfolio according to the capital asset pricing theory must include every marketable asset (Khalaf, 2010). The assumption behind the market portfolio is that market index performance is impacted by every factor in the economy. The use of proxy portfolio is very controversial and this leads to the questioning of the validity of the Capital asset pricing model. Capital asset pricing model measure of a security future risk (Beta) is constant. In a real security market, investors do not have future information about the market to estimate beta. Investors only have past information about the market portfolio, performance of different organizations and prices of shares. Therefore, investors can only estimate the measure of a security future risk using historical data. The use of a historical beta is only applicable in case the beta is stable over time. Research has shown that betas for different securities are not constant over time. Therefore, historical betas are poor indicators to determine future risk of securities. B) Describe Roll’s critique of the early empirical tests of the Capital as
Capital asset pricing model assumptions are unrealistic and deviate far from the real life happenings. The model assumes that short-term government securities are risk-free. It is difficult to find risk free securities. Government securities are unlikely to be defaulted but factors such as inflation creates uncertainty on the real rate of return. …
Risk free rate + ? (Average Market Return –Risk free rate) Where ? is the beta value of the financial asset The basic assumptions of this model pose as disadvantageous for this model to be considered as a perfect representative of required return calculation.
This concept holds that an investor’s time value of money and level of risks must be considered while rewarding him. These factors are generally computed using a risk measure called beta. Although the CAPM is widely used for anticipating the feasibility of an investment decision, this model has a number of corporate applications also.
The Capital Asset Pricing Model (CAPM)
For an open market place, an idealized framework is assumed. In this market, stocks available for trade are assumed to risky assets. Moreover, there are also those assets that are not associated to any risk and customers borrow whichever the quantity they want since there are no stipulations limiting quantities to be borrowed.
Capital Asset Pricing Model.
CAPM (Capital Asset Pricing Model) The CAPM model has emerged to be one of the most important tools in making a fundamental decision related to the investment management. It measures the relationship between the expected rate of return and the risk involved in a particular investment The CAPM tool signifies the linear relationship between the non diversified systematic risks which is measured by beta ?
It is essentially used to price the most risky assets. As a mathematical model for equilibrium in financial markets and portfolio theory (Markowitz), the CAPM core basis is the relationship that exists between the risk of a security and its yield, and it is measured through a single beta factor for risk (Plesmann, 2010.p.54).
James Bradfield (2007, p167) defines portfolio as an assortment of securities. Portfolio theory actually is nothing but a traditional analysis of the association between risk and returns on risky securities. The theory is useful for investors. It assists them to determine and apportion their funds in securities which are risky thus generating a portfolio.
Despite these efforts, it is evident that risks remain a vital and its mitigation needs to be properly consummated. Aside from these concepts, the financial world is also familiar with the term uncertain. Essentially, this refers to the incapability of providing comprehensive list of outcomes and indefinite probabilities.
Several academicians and scholars have argued on the empirical validity of the CAPM theory and claim that the model has several technical and empirical problems [Fama and French (2004), Michailidis (2006), Ryan (2006), (Soufian, 2001) etc]. There are several criticisms on the empirical effectiveness of the CAPM theory viz.
The paper "Capital asset pricing model (CAPM)" gives the detailed information about Developments in the Capital Asset Pricing Model. The foundation of Capital asset pricing model was established in an article of a finance journal in the year 1963 named, Capital Asset Prices: A theory of market equilibrium under conditions of risk.
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