Capital asset pricing model - Essay Example

? CAPM by + A) Discuss the main theoretical limitations of the Capital asset pricing model. Capital asset pricing model assumptions are unrealistic and deviate far from the real life happenings. The model assumes that short-term government securities are risk free. It is difficult to find risk free securities. Government securities are unlikely to be defaulted but factors such as inflation creates uncertainty on the real rate of return. The model also assumes that the lending rate and the borrowing rate are equal. In practice, these two rates differ and therefore, the model will not hold in a real life scenario. The model also assumes that there is no transaction cost, taxes or holding period of the securities. However, these costs exist and they vary from one investor to another. Additionally, investors are not always holding a highly diversified portfolio of securities. The market indices of the securities market may not always diversify well. The capital-pricing model will not explain investors’ behavior and the beta might fail in capturing the risk of investment in real life practice due to these factors. Therefore, the model fails to act as a uniform and efficient valuation model in a real practical situation. The model only works in a generalized situation that is when dealing with a portfolio, but fail if the investment is broken down into single forms of securities. The capital asset pricing model assumes that the higher the risks the higher the return and that all the investors are risk averse (Surajit, 2009). The model assumes that securities are highly divisible into small parts. The model further, assumes that all investors access information at the same time and that investors make decisions based on a single period horizon. The capital asset pricing model is practically difficult to validate. Empirical validation of the capital asset pricing model has to establish that beta has ability to measure the risk of a security (Szyszka, 2009). It also has to show that there is a significant correlation between beta and the expected rate of return. The empirical results have however, being of mixed outcomes. The results have shown that the relationship is not as strong as the capital asset pricing model indicates. The results also have also shown that the expected returns are also related to other measures of risk, which includes firm’s specific risk. Other factors such as market value and book value ratios relationship with returns were found to be significant. In order to test capital asset pricing model empirically researchers need to use data on expected prices. However, the data available is historical information only. This therefore, will result to biased empirical results. The capital asset pricing model assumes that the market portfolio consists of all the assets in all the markets. The market portfolio according to the capital asset pricing theory must include every marketable asset (Khalaf, 2010). The assumption behind the market portfolio is that market index performance is impacted by every factor in the economy. The use of proxy portfolio is very controversial and this leads to the questioning of the validity of the Capital asset pricing model. Capital asset pricing model measure of a security future risk (Beta) is constant. In a real security market, investors do not have future information about the market to estimate beta. Investors only have past information about the market portfolio, performance of different organizations and prices of shares. Therefore, investors can only estimate the measure of a security future risk using historical data. The use of a historical beta is only applicable in case the beta is stable over time. Research has shown that betas for different securities are not constant over time. Therefore, historical betas are poor indicators to determine future risk of securities. B) Describe Roll’s critique of the early empirical tests of the Capital asset pricing model. Roll argues that Capital asset pricing model is testable in principle only. He argues that there is no possibility of practically accomplishing such a test. Roll argues that the capital asset pricing model is not testable unless the market portfolio of all assets is observable and used in empirical tests (Grauer, 2009). Therefore, he concluded that it is hard to test capital asset pricing model in a strict sense. He also argues that it is not possible to observe similar composition of securities of the true market portfolio. In other words Roll argues that it is impossible to make up a portfolio that contains every single security that is a true market portfolio. He states that it's not theoretically clear which assets can be excludable and that the available data considerably limits the assets included. This therefore, forces capital asset pricing model to use proxies for the market portfolio. The capital asset pricing model shows that the relationship between market beta and the expected return is just the minimum variance that holds for any portfolio (Bhaskaran, 2009). He therefore, says that in case a market proxy on a minimum variance frontier it will be used for describing differences in the expected returns. However, researchers are yet to discover a practical market proxy close to the minimum frontier. Roll argues that one can never determine the extent to which deviations from security market targets are as a result of inadequacies from the market portfolio or due to something real. C) How successfully does the Arbitrage Pricing Theory (APT) address the weaknesses of the CAPM that you have identified in parts (a) and (b)? Arbitrage pricing theory insists on covariability of an asset’s return as compared to return on other assets rather than its total variability. In arbitrage pricing theory is an equilibrium pricing model, where return on any risky assets is a linear combination of several common factors affecting asset returns (Armstrong, 2012). Capital asset pricing model on the other hand depicts that equilibrium rate of return on all risky assets as a function of their covariance with the market portfolio. Capital asset pricing model derivation requires very technical assumptions but arbitrage pricing theory exploits the concept of many asset security markets (Perold, 2004). Many people consider the ability of arbitrage pricing theory to accommodate several securities with systematic risk as the advantage the theory has over capital asset pricing model. This is due to the fact that the market portfolio is not the main determinant factor of arbitrage pricing theory. Covariance of an asset’s return with factors that systematically influence the returns on most assets is the factor that determines the expected return (Devinaga, 2011). Arbitrage pricing theory does not imply an exact linear risk return relation even as the number of assets increases to infinity. It is argued that arbitrage pricing theory in contrast to the capital asset pricing model may be tested by simply observing subsets of the set of all returns. It is argued that capital asset pricing model main criticisms is that it is not testable and arbitrage pricing theory came as a testable alternative. Reference Armstrong, J., 2012. Exchange Risk and Universal Returns: A Test of International Arbitrage Pricing Theory. Pacific-Basin Finance Journal, 20 (1), pp. 22-40. Bhaskaran, S., 2009. Testing International Asset Pricing Models Using Implied Costs of Capital. Journal of Financial and Quantitative Analysis, 44 (2), pp. 307-350. Devinaga, R., 2011. The Effectiveness of Arbitrage Pricing Model in Modern Financial Theory. International Journal of Economics & Research, 2 ( 3), pp. 125-135. Grauer, R., 2009. On the Power of Cross-Sectional and Multivariate Tests of the CAPM. Journal of Banking & Finance, 33 (5), pp. 775-787. Khalaf, L., 2010. Asset-Pricing Anomalies and Spanning: Multivariate and Multifactor Tests with Heavy-Tailed Distributions. Journal of Empirical Finance, 17 (4), pp. 763-782. Perold, A., 2004. The Capital Asset Pricing Model. The Journal of Economic Perspectives, 18 (3), pp. 3-24. Surajit, S., 2009. Testing the CAPM revisited. Journal of Empirical Finance, 16 (5), pp. 721-733. Szyszka, A., 2009. Generalized Behavioral Asset Pricing Model. IUP Journal of Behavioral Finance, 6 (1), pp. 7-25. Read More