Critique of the Capital Asset Pricing Model Approach - Term Paper Example

The paper "Capital Asset Pricing Model Approach" is an excellent example of a term paper on finance and accounting. Most financial theories experience some difficulties in their practical applications. 

The model assumes a tax-free investment trading and again that the returns on investment are not affected by the taxes (Pratt and Roger, 2010). This is however not true because capital gains tax is charged on any investment transaction. This, in essence, is an additional transaction cost. Further, expected returns to investors are reduced by taxes implying an impact on the way they price their investments. In addition, different returns can be taxed differently facilitating investors to select those portfolios consisting of assets that have favorable tax levels.

Finally, the same assets can be priced differently because of different taxes levied on different investors. It is therefore evident that the assumption of zero tax is not reasonable (Kürschner, 2008). Borrowing at risk-free ratesThe assumption that investors can freely borrow or lend money at the same rate that is risk-free is not applicable in the real capital market especially for smaller and non-institutional investors (Pratt and Roger, 2010). Because of the added premiums, individual investors are not able to borrow at this risk-free rate like others do by buying government bonds.

The difference in the borrowing rate and lending rate, therefore, predicts that the capital market line should be downwardly kinked for a riskier portfolio (Kürschner, 2008). The fact that it is downwardly kinked shows that the risk-free borrowing cost is higher than the risk-free lending cost. Availability of risk-free assets To allow for adjustment in the portfolio risk, the model assumes that zero-risk securities with different maturities are available in sufficient quantities (Kürschner, 2008).

This is not practical because even the most secure securities like treasury bills are faced with numerous risks such as inflation risk, currency risk, and reinvestment risk (Pratt and Roger, 2010). Zero transaction costs In real market conditions trading cannot be costless as assumed by the CAPM.