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Disadvantages of Capital Asset Pricing Model

Disadvantages of Capital Asset Pricing Model

DISADVANTAGES OF THE CAPM

The CAPM suffers from a number of disadvantages and limitations that should be noted in a balanced discussion of this important theoretical model.

Assigning values to CAPM variables

In order to use the CAPM, values need to be assigned to the risk-free rate of return, the return on the market, or the equity risk premium (ERP), and the equity beta. (Jones, 2008, 11-13) The yield on short-term Government debt, which is used as a substitute for the risk-free rate of return, is not fixed but changes on a daily basis according to economic circumstances. A short-term average value can be used in order to smooth out this volatility. (Jones, 2008, 11-13) Finding a value for the ERP is more difficult.

The return on a stock market is the sum of the average capital gain and the average dividend yield. In the short term, a stock market can provide a negative rather than a positive return if the effect of falling share prices outweighs the dividend yield. It is therefore usual to use a long-term average value for the ERP, taken from empirical research, but it has been found that the ERP is not stable over time. (Jones, 2008, 11-13) In the UK, an ERP value of between 2% and 5% is currently seen as reasonable. However, uncertainty about the exact ERP value introduces uncertainty into the calculated value for the required return. Beta values are now calculated and published regularly for all stock exchange-listed companies. The problem here is that uncertainty arises in the value of the expected return because the value of beta is not constant, but changes over time. Using the CAPM in investment appraisal Problems can arise when using the CAPM to calculate a project-specific discount rate.

The Capital Asset Pricing Model (CAPM)•Some, but not all, of the risk associated with a risky investment can be eliminated by diversification. The reason is that unsystematic risks, which are unique to individual assets, tend to wash out in a large portfolio, but systematic risks, which affect all of the assets in a portfolio to some extent, do not. (Jones, 2008, 11-13)

•Because unsystematic risk can be freely eliminated by diversification, the systematic risk principle states that the reward for bearing risk depends only on the level of systematic risk. The level of systematic risk in a particular asset, relative to average, is given by the beta of that asset.

•The reward-to-risk ratio for Asset i is the ratio of its risk premium, E(Ri) - Rf, to its beta, Bi:[E(Ri) - Rf]/Bi•In a well-functioning market, this ratio is the same for every asset. As a result, when asset expected returns are plotted against asset betas, all assets plot on the same straight line, called the security market line (SML).

•From the SML, the expected return on Asset i can be written:E(Ri) = Rf +Bi[E(Rm) - Rf]•This is the capital asset pricing model ...

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