Question

Show 2 limitations of the one-factor CAPM model and explain their consequences on the valuation of securities.

Answer 1

LIMITATIONS OF ONE FACTOR CAPM MODEL & ITS CONSEQUENCES ON VALUATION OF SECURITIES -

Two limitations on the one-factor CAPM model are-

1) Return on the market rate and

2) Ability to borrow funds at the risk-free rate.

Issue with the return on the market is that it is only an estimate or guess. The real return on the market is always quite different. It can even be negative in the short-term. Further, the return on the market is historical and not forward-looking.

Another limitation is the questionable ability to lend or borrow funds at the risk-free rate, which is an assumption of the model. The risk free rate is usually the rate on very short term US Treasury securities. The US government may be able to borrow at that rate but individual citizens can't.

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