Discuss the problems associated with CAPM PDF

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Essay discussing the problems with CAPM...

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Although empirical evidence does tend to support CAPM quite strongly there are several problems which are associated with CAPM theory One of the first issues associated with CAPM is deciding how to measure the beta value to be used as part of the model in order to help draw insights for the future. It is unclear regarding whether the beta value should be measured based on daily, weekly, monthly or yearly data. Hence due to this lack of clarity over which observation period is best to use in order to estimate CAPM, the model may produce unreliable results. Another key issue with CAPM is the application of historical data in order to obtain predictions and results to inform future decisions. This application of ex-ante theory for expost results is unreliable as expectations for the future based on past data often do not materialise and hence the CAPM model may produce unreliable results through basing future predictions on historical data. The market portfolio which is key to CAPM through providing values such as return on market portfolio and standard deviation of market portfolio also causes an issue with CAPM. A market portfolio is often very difficult to obtain and hence finding accurate above values is hard and hence the predictions of CAPM may consequently be inaccurate. The market portfolio values often have to be approximated by using values based on an index such as the FTSE all share index. The one period nature of CAPM can also be another issue. As CAPM is a one period model, it arguably should not be used to make predictions for across multiple time periods. However, many investors are thinking about long term prospects regarding any prospective investment they make and CAPM lacks substance in informing investors regarding this. CAPM results are based on certain parameters and over time the value of these parameters are likely to change and hence it is likely quite unreliable in making predictions longer term regarding investment. Another issue regarding CAPM is the requirement of a risk-free rate of return. The reality is that very few securities have 0 risk i.e. are risk free. Although bonds and treasury bills of reputable governments, such as the UK and USA who have never defaulted on debt payments, may be risk free there are several other examples of countries, such as Greece and Argentina, where countries have failed to carry out debt obligations. Hence, finding a risk-free asset and hence the relevant values for CAPM is often tough. Consequently, predictions of the model may be unreliable.

The assumptions made as part of CAPM are also another problem as many of these are unrealistic assumptions. In practice, a lot of investors will not be 100% rational utility maximisers as they may not have the capacity to do this. In practice, a lot of them may use generic rules of thumb in order to invest and hence this assumption of CAPM is unrealistic. Furthermore, information is time consuming and expensive to obtain for most individuals in practice who are looking to invest and hence a lot of investors likely do not incorporate all information available to them as part of investment decisions. Hence, the assumption of CAPM that information is freely available is also violated. In addition to the above two assumptions, investors in practice can often not borrow and lend at the risk-free rate and securities are often not infinitely divisible in practice. Furthermore, capital markets do not always remain perfectly competitive and frictionless hence due to all of the above assumptions of CAPM being violated in practice we can see that this also causes significant problems in questioning the use of CAPM and its findings in practice....