Main Limitations of Capital Asset Pricing Model - Essay Example

As the model measures risk through the deviation of asset returns, many factors like inflation, which affect the portfolio returns are not considered. In addition, the asset returns can be irregular while calculating in real practice. However, the CAPM model assumes the asset returns to be normally distributed. The real-world distribution of such returns is non-normal. (Limitations of CAPM, 2012)

Investment costs also differ according to the ability of the investors to invest in the required portfolio. Accordingly, it is impractical to assume that security returns will remain identical for CAPM to determine the most efficient portfolio for the investors. Similarly, risk-taking ability and preference vary among investors, as many may choose low-risk securities and some may go for high-risk ones. In addition, there are many assumptions, which may not be correct for the process of application of CAPM. Finding risk-free security remains the favorite dream of many investors. However, in reality, there is nothing like a risk-free investment. The government's short-term security is considered the most liquid with the least risk, as governments are unlikely to default. However, inflation plays the spoilsport, as it is related to return variance. The borrowing and lending rates also differ and may not be uniform, since the markets may not behave according to pre-set assumptions. CAPM application is based on such assumptions, which cannot work in the real world.  (Limitations of CAPM, 2009)

Roll’s critique of an early empirical test of the CAPM

After the development of CAPM, many tests were conducted to ascertain the accuracy of this application in predicting the correct asset values. The tests were based on proxy values for different variables. However, in most of the cases, CAPM could not predict the accurate asset values and it did not prove suitable for such predictions. In the year 1977, Richard Roll opined that CAPM could not be tested empirically, although it may prove valid theoretically. The reason for this, according to Roll is the variation in stock indexes, which may not prove good proxies for CAPM variables. (Taylor, 2005)

In the CAPM formula: E(Ri) =RF +βi [E(RM) - RF ], ‘Beta i’ represents the systematic risk for security ’i’, while ‘RF’ means the risk-free return and E(Ri) represents the expected return on security ‘i’.

Roll criticized this formula arguing that the index portfolio used here for estimation of ‘betas’ is based on the assumption of efficient property of securities. However, the CAPM does not assert the true market portfolio is an efficient one. The mathematical fact mentions that expected return from security has a linear relation with the systematic risk, and portfolio returns and betas have also a similar relationship. The basis of this calculation is the efficient set of index portfolios. CAPM assumptions, according to Roll do not hold good here.

Roll has opined that it is impossible to test the CAPM validity since it is related to the efficiency of market portfolios and it may not be possible to observe the investment opportunities based on their expected returns. (The main theoretical limitations of CAPM)

CAPM vs. APT

Arbitrage is involved when an investor gets a return on a zero beta investment portfolio, which is greater than any risk-free rate of return. This happens when the investor has a choice of selling high priced portfolio while buying the low-priced one when the two portfolios are not evenly priced. However, such opportunities are not sustainable in any efficient market. APT will apply to the diversified portfolios and not for a single security. As compared to CAMP, arbitrage pricing is possible for any market portfolio, since an expected return is possible without any assumptions, while APT can access all the multi-factor models. (Capital Asset Pricing and Arbitrage Pricing Theory)

CAPM theory, as indicated by the empirical evidence, is not able to determine the cross-sectional expected returns, as several other factors are required to examine the pattern of such returns. In comparison, APT will not need the market portfolio identification, since it is more general in nature that can work with multiple risk factors. In addition, the ability to price assets beyond the used sample, for estimation purposes, determines the validity of APT. (Soufian, 2001)