Capital Asset Pricing Model Assignment Example | Topics and Well Written Essays - 1000 words

Capital Asset Pricing Model - Assignment ExampleUsually, the overall capriciousness of the grocery is measures through proxies when implementing this exemplification, for instance, the use of FTSE index. Such proxies are not usually the true measures of the market volatility which is at the core of the CAPM assumptions. Therefore, the model estimations from CAPM with use of market proxies for volatility can unaccompanied predictions that are approximates and not the accurate measures of risk and return relationships. Another un receivedistic assumption the CAPM model makes is the existence of a scanty risk security. In reality, there is not security that is free from risk. Usually, researchers use government security as a risk free security. The truth is objet dart the government may not default (thus considered no risk), other factors such as inflation are uncertain and may impact on the real rate of return. There is also the assumption in the CAPM that the lending and borrow ing rates are equal. In reality, this is incorrect as these rates usually differ. The model also makes an assumption that investors will hold passing diversified portfolios. This is not always the case as investors may not hold such highly diversified portfolios and therefore the entire market indices may not be well diversified. This therefor affects the results of CAPM model in estimating market returns. It is therefore unlikely, given these assumptions, that investors conduct can be accurately explained by this model and also accurately measure the risk of investment. Another limitation of the CAPM model is that given the assumptions it makes, it is difficult to point its practical validity as well as its confirmable validity. Empirical results on whether there is a significant relationship between beta and evaluate return has been mixed. For instance, some studies have rig positive but weak correlations. Others have revealed that returns were not only related to betas but a lso with other risks such as firm specific risks. Further, other studies find no relationship between beta and returns. Returns have also been found to be highly match with other factors such as size of the firms, market and book value ratios, among other factors. These call for need to establish whether beta can be apply to measure the risk of securities and whether it is correlated with expect return. Without this, practical and empirical validity cannot be assumed. Another conceptual problem that is linked to validity is the fact that empirical studies on CAPM model have used actual past data and not expected prices to test the model. This introduces bias and there is need to use expected prices to test the model to examine its validity. Another assumption of capital asset pricing model is that betas are assumed to remain stable over time. This is not possible. From the model, beta is a measure of future risk of securities. Investors on the other hand only have past data of sha re prices and market portfolios, and not future data. Beta can therefore only be estimated from past data. When past data is used to measure beta, such beta can only be a reliable measure of future risk if it can remain stable over time. This is not possible as studies have found that individual securities do not remain stable over time. Therefore, historical betas are not good predictors of future risk of securities. Describe Rolls critique of the early empirical tests of the CAPM. Roll has two issues with the CAPM model. The first criticism is stemmed from one of the