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Financial Economics - Essay Example

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Limitations of Capital Asset Pricing Model and Arbitrage Pricing Theory as an Alternative Theoretical Limitations of CAPM Capital Asset Pricing Model is indicative of the relationship between the risks associated with an asset and the returns, which can be expected thereof (Giovanis, 2010)…
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Financial Economics
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Financial Economics

Download file to see previous pages... Under CAPM, the variations associated with returns are considered as sufficient measure of the risk related to a particular portfolio. But, on the other hand, there are several other risk factors, which may be considered as influential in the determination of risk involved in the investment in a portfolio. Apart from this, as per the assumption made in CAPM, returns related to assets are deemed to be normally distributed, which in real life situation, cannot be guaranteed as such (Kurschner, 2008). In addition to this, it is also pertinent to note that investors do not possess the same ability to invest and therefore investment costs to be borne by them may vary significantly. Similarly, assumptions relating to no variations in the expected returns and the concept of asset market without friction can also be considered as unfeasible. In fact, markets, which are assumed to be frictionless are reflective of situations where there exist no costs of transaction and other costs relating to taxes or any limit on transactions. Moreover, the model also presumes that the assets traded in the market can be segregated to an infinite extent, thus enabling them to be held or sold. Apart from these limitations, one other significant limitations associated with the model is that CAPM does not require investors to take into consideration unsystematic risk, as the model presumes that it is not difficult to diversify such risks. But, since returns are directly related to the returns on market portfolio, therefore it is not possible to eliminate such risks with mere diversification (Kurschner, 2008). Roll’s Critique of the Early Empirical Tests of the CAPM Based on the empirical testing of the CAPM, Roll’s critical evaluation of the model relates to the determination of the fact that whether CAPM equation is valid and does it hold its ground? As per the equation of CAPM, E (Ri) signifies the returns expected from investment in a security “i” (Roll, 1977). On the other hand, Rf is representative of the risk free return and ? represents systematic risk associated with the security for expected returns are to be determined. Moreover, it is also pertinent to note here that under CAPM making use of expected returns in relation to a real market portfolio carries out the evaluation of investment portfolio. As per the criticism of Roll, there is a relationship between systematic risk and returns expected from investment in a security, which is linear, provided that the value for ? is determined in the form of an index portfolio. Apart from this, the intercept also equates with the return when a portfolio with minimum return is considered. In light of these findings, it can be stated that the assumptions of the model are not required (Roll, 1977). Moreover, Roll also argued that as Capital Asset Pricing Model is concerned with the mean and variances therein in relation to efficiency of market portfolios and since it is not possible to observe the investments for which returns are being determined through it, it is therefore not possible to evaluate the model through empirical testing (Roll, 1977). Arbitrage Pricing Theory as an Alternative to CAPM’s Limitations The Arbitrage Pricing theory reflects that pricing of an ...Download file to see next pagesRead More
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