Question

Discuss three strengths and three weaknesses of the Capital Asset Pricing Model when its applied to calculate the expected return on stock

Answer 1

Strengths of the CAPM model

1. CAPM model considers only systematic risk which is a very realistic assumption because almost all portfolio held in reality are well diversified to eliminate the unsystematic risk

2. The CAPM model is an extremely simple way to calculate the expected return on the stock. There are no complex calculations and any person can calculate the expected return on a stock in very less time.

3. The expected return calculated using CAPM is easily comparable across different securities since the underlying assumption is made of risk-free rate and the market index return, which is common across securities.

The weakness of the CAPM model

1. The risk-free rate is assumed to be a 90-day treasury rate. In reality, this risk-free rate fluctuates every day which gives rise to volatility. Also, which treasury rate to consider eg. 90 days, 180 days, etc is subject to pros and cons.

2. The return on the market is assumed to be returned on a market index. The market index is itself subjective and one can argue that the market is represented by 100 securities, another can argue that the market is represented by 500 securities. In short, what constitutes the market index is subjective and depends on the analyst.

3. The ability of the investor to borrow and lend at the risk-free rate is a flawed assumption since in reality there is always a risk premium attached with borrowing and lending.