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Capital asset pricing model - Essay Example

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Capital asset pricing model

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 ...Show more

Summary

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. …
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Capital asset pricing model essay example
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