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Explain the limitations of the Capital Asset Pricing Model and the extent to which the multi-factors approach has overcome these limitations - Essay Example

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Capital pricing model is mainly used or applied to establish the relationship between the risk and the expected rate of return in order to evaluate the price of high risk securities. It can be established with the following formula (Berk and DeMarzo, 2007).
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Explain the limitations of the Capital Asset Pricing Model and the extent to which the multi-factors approach has overcome these limitations

Download file to see previous pages... Under the efficient frontier the portfolio generally has minimum risk and it measures the variance of returns therefore it is known as the minimum variance portfolio with the minimum rate of return and the maximum return portfolio which includes maximum risk. The portfolio that stands below the efficient frontier mainly provides less return for the same level of risk (Nonaka, 2001).
CAPM explains the extent to which the asset is priced in terms of the risk. The APT is considered as another equilibrium pricing model. The CAPM mainly faces criticism which is not testable. Therefore APT is considered as alternative to testable. The combination of the different factors is estimated for finding out the return on the asset that is risky which affects the return on the assets.
The various possible portfolios are represented on the various indifference curves that generally do not yield high return for the same level of risk. These portfolios generally stand below the efficient frontier. The optimal portfolio can be defined as the portfolio on the efficient frontier that yields the best combination of the risk and return for the specific investors which will provide maximum possible satisfaction for the investors (Markowitz, 2008)
CAPM model is mainly based on the various assumptions that differ from reality. This creates a problem in explaining accurately the Capital asset pricing model related to the investment attitude of the investor and the beta may not be able to determine the risk of investment. It is very difficult to calculate the project related discount rate.
Beta measures and estimates the future risk of the securities therefore it is expected that beta must remain stable and constant. But under CAPM model beta does not remain stable therefore it creates problem for the investors in estimating the data.
The main limitation of CAPM model is that only single time period horizon is taken into ...Download file to see next pagesRead More
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