Question

"The international capital asset pricing model is an appealing theory but has little practical use." Critically analyse this statement.

Answer 1

Formula for Capital Asset Pricing Model is

Risk Free Rate + Beta of the security*(Market Rate - Risk Free rate)

The little practical use or disadvantages of the same can be discussed as below -

a. Risk free rate -

The return of equity is calculated using Risk free rate plus surplus of Market rate over risk free rate multiplied by Beta, Risk free rate changes on a frequent basis which can lead to volatile returns being portrayed.

b. Market rate- It is the sum of dividends paid plus the capital appreciation in terms of share price over a period. The market returns can be negative at any point of time (e.g during slow down, trade wars, depression) leading to improper expected return being calculated. Any returns considered are past data which may not be iterated in future.

c. Borrowing at risk free rate - CAPM model assumes that the borrowings can be made at Rf which si very nominal rate. Corporations are unable to borrow at the same rate as borrowed by Government.

d. Dummy /Proxy Beta - Entities using CAPM to evaluate an investment need to find beta indicative to the project or investment. In many cases, a proxy/dummy beta is required. However, accurately determining the same to properly assess the project is difficult and can affect the reliability of the expected return.

e. Assumption of a perfect market - Model assumes that securities are valued correctly & their returns will plot on to the SML. A perfect capital market assumes the following : no taxes or transaction costs (normally present in form of Gain taxes & brokerages) ; that perfect information is freely available to all investors for decision making that all investors are risk averse, rational and are willing to maximise their own utility; presence of large population of buyers and sellers (which is not possible in case of developing markets where the proportion of stock market players as compared to population is low).

f. Other Misc Factors not considered- Other factors influencing the return of security like inflation sensitivity, dividend payout, are not considered.