Limitations of Capital Asset Pricing Model

Capital asset pricing model has the following limitations:

o It is based on unrealistic assumptions.
o It id difficult to test the validity of Capital asset pricing model.
o Betas do not remain carport over time.

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Unrealistic assumptions

Limitations of Capital Asset Pricing Model

Capital asset pricing model is based on a estimate of assumptions that are far from the reality. For example it is very difficult to find a risk free security. A short term extremely liquid government security is considered as a risk free security. It is unlikely that the government will default, but inflation causes uncertain about the real rate of return. The assumption of the equality of the lending and borrowing rates is also not correct. In custom these rates differ. Additional investors may not hold extremely diversified portfolios or the store indices may not well diversify. Under these circumstances capital asset pricing model may not accurately explain the investment behavior of investors and beta may fail to capture the risk of investment.

Difficult to validity

Most of assumptions may not be very requisite for its practical validity. Therefore is the empirical validity of capital asset pricing model. Need to develop that the beta is able to quantum the risk of a security and that there is a requisite correlation in the middle of beta and the predicted return. The empirical results have given mixed results. The earlier tests showed that there was a positive relation in the middle of returns and betas. However the association was not as strong as predicted by capital asset pricing model. Additional these results revealed that returns were also linked to other measures of risk, including the firm exact risk. In subsequent explore some studies did not find any association in the middle of betas and returns. On the other hand other factors such as size and the store value and book value ratios were found as significantly linked to returns.

All empirical studies testing capital asset pricing model have a conceptual problem. We need data on predicted prices to test it. Unfortunately, in custom the researchers have to work with the actual past data. Thus this will introduce bias in the empirical results.

Betas do not remain carport over time

Stability of beta, beta is a quantum of a securities future risk. But investors do not Additional data to evaluation beta. What they have are past data about the share prices and the store portfolio. Thus, they can only evaluation beta based on historical data. Investors can use historical beta as the quantum of future risk only if it is carport over time. Most explore has shown that the betas of personel securities are not carport over time. This implies that historical betas are poor indicators of the future risk of securities.

Capital asset pricing model is a useful device for understanding the risk return association in spite of its limitations. It provides a logical and quantitative advent for estimating risk. It is best than many alternative subjective methods of determining risk and risk premium. One major question is that many times the risk of an asset is not captured by beta alone.

Limitations of Capital Asset Pricing Model

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What Gift Should You Give Your protection Guard?