capital asset pricing model

Capital Asset Pricing Model Assumptions and Limitations

Capital Asset Pricing Model – A framework which determines the rate of return of an asset and shows the relationship between return and risk of an asset.

With CAPM model one can also compare the rate of return on asset with its required rate of return. This is important to determine whether the asset is fairly valued or not. The important thing to note that, under CAPM  model, security Market Line (SML) highlight the relationship between an asset’s risk and required rate of return.

CAPM Assumptions

  • Market Efficiency – This implies that the capital market is efficient and information is readily available. It also signifies that an individual investor cannot affect the prices of the securities. This implies that there are large number of investors available holding a small proportion of wealth.
  • Investors are risk averse – All the investors are risk averse. They prefers higher level of returns at a given level of risk.
  • Risk Free rate – Investors can lend and borrow at a risk free rate of interest. Their portfolio consists of bonds and shares.
  • Homogeneous expectations – All the investors have same expectation with respect to risk and return from the securities.

Relevance of Capital Asset Pricing Model

CAPM has following implications –

  • Investors always combine a market portfolio of risky assets with that of risk free assets. They invest in risky assets with respect to their market value.
  • Investors get compensation for the risk they cannot diversify. This is called the systematic risk. Beta is one of the most appropriate measure of an asset’s risk.
  • There is a linear relationship between expected return and its beta. So, investors can expect returns from their investment according to risk.

Limitations of CAPM

The model has following limitations –

  • Unrealistic Assumptions – The model is based on unrealistic assumptions. For example, it is very difficult to find a risk free security. Well, a government security is considered as risk free asset but due to the inflation factor there is uncertainty about the real rate of return.
  • Testing the validity of CAPM – All the studies that tries to test the validity of CAPM have a conceptual problem.It is an ex-ante model that is, it requires data on expected prices to test CAPM. In reality researchers work with past data  which could lead to bias empirical studies.
  • Stability of Beta – Beta is a measure of risk involves in investing in an asset. However investors do not have sufficient data to estimate the beta correctly. They just have the past data about the share prices and market. So they can estimate beta on the basis of historical data.

Related Financial Terms of CAPM