Question

Discuss the main problems of using CAPM in investment appraisal

Problems around assumptions should be discussed

CAPM assumptions

•   There is a single risk-free rate.

•   Shareholders hold diversified portfolios and are only interested in market/systematic risk

•   Assumes return is purely a function of a single variable (market risk)

•   Single period model

•   Perfect markets (no transaction costs, equal borrowing rates, personal taxes have no impact, etc.)

•   Normative model (What ought to be?)

Answer 1

Main problems/limitations of using CAPM (Capital Asset Pricing Model) in investment appraisal :

1. Many investors do not invest in a diversified manner and hence their unsystematic risk still persists which is not taken into account by CAPM based expected return. (assumption criticism)

2. Beta coefficient may be unstable and may not be reflective of the true risks involved. Beta may not reflect the future volatality of returns owing to its unstable nature.

3. CAPM mainly focusses attention on systematic risk, although empirical study has shown that total risk is found to be more effective in determining the expected returns. Both risks are found to be positively correlated to returns. (assumption criticism)

4. The analysis of Security Market Line, i.e the graphical representation of CAPM, is not applicable to bond analysis , although bonds are an integral part of portfolios of many investors.

5. CAPM is a single period model and it is all based on mere estimates of beta, risk free rates etc which are quite difficult to ascertain in reality.

6. The assumption that all investors are rational is also quite vague as it depicts an ideal picture of a well structured market.