Wednesday, December 2, 2009


Limitations of Capital Asset Pricing Model

Capital asset pricing model has the following limitations,
  • It is based on unrealistic assumptions.
  • It id difficult to test the validity of Capital asset pricing model.
  • Betas do not remain stable over time.
Unrealistic assumptions
Capital asset pricing model is based on a number of assumptions that are far from the reality. For example it is very difficult to find a risk free security. A short term highly 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 practice these rates differ. Further investors may not hold highly diversified portfolios or the market 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 critical for its practical validity. Therefore is the empirical validity of capital asset pricing model. Need to establish that the beta is able to measure the risk of a security and that there is a significant correlation between beta and the expected return. The empirical results have given mixed results. The earlier tests showed that there was a positive relation between returns and betas. However the relationship was not as strong as predicted by capital asset pricing model. Further these results revealed that returns were also related to other measures of risk, including the firm specific risk. In subsequent research some studies did not find any relationship between betas and returns. On the other hand other factors such as size and the market value and book value ratios were found as significantly related to returns.
All empirical studies testing capital asset pricing model have a conceptual problem. We need data on expected prices to test it. Unfortunately, in practice the researchers have to work with the actual past data. Thus this will introduce bias in the empirical results.
Betas do not remain stable over time
Stability of beta, beta is a measure of a securities future risk. But investors do not further data to estimate beta. What they have are past data about the share prices and the market portfolio. Thus, they can only estimate beta based on historical data. Investors can use historical beta as the measure of future risk only if it is stable over time. Most research has shown that the betas of individual securities are not stable 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 relationship in spite of its limitations. It provides a logical and quantitative approach for estimating risk. It is better than many alternative subjective methods of determining risk and risk premium. One major problem is that many times the risk of an asset is not captured by beta alone.


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