Strengths And Weaknesses Of Capital Asset Pricing Model

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Introduction This report discusses about the strengths and weaknesses two types of asset pricing theory - Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT). The CAPM model shows the relationship between the fair expected returns and the systematic risk of a portfolio. Figure 1 shows the formula of CAPM. The APT model also shows the relationship between the fair expected returns and risk in line with the law of one price, taking into account both systematic and unsystematic risks. Figure 2 shows the APT formula. Figure 2 CAPM- Strength CAPM includes systematic risks in its calculations. Systematic risks are risks that are caused by macroeconomic factors like war, recession, inflation, interest …show more content…

Assume 2 investors, Mr. A holding a portfolio of β > 1 and Mr. B, holding a portfolio of β < 1. Mr. A would have a greater impact on his returns during The Great Recession than Mr. B. However, if Mr. A had used the CAPM model and recognised that his portfolio is a volatile one, he would have demanded for high returns. Hence the high returns earned prior to The Great Depression would compensate for the loss suffered during the recession. CAPM - WEAKNESSES The assumptions for this model is listed in Appendix 1. The following discussion is based on these assumptions. The CAPM assumes that there are unlimited short sales in the investment universe. The U.S. Securities and Commission defines short sales as “sale of a stock you do not own”. However this assumption does not entirely hold in today’s world. According to the U.S. Securities and Commission “it is prohibited for any person to engage in a series of short sales transactions.” According to the Chartered Financial Analyst board, for the CAPM to be valid at least two of its key assumptions need to be true: “there are no restrictions on risk – free borrowing and/or no restrictions on short sales.” This clearly shows that the CAPM is no longer valid to be used in markets that have restrictions imposed on short – sales as the market portfolio can be inefficient and the relationship between …show more content…

This is indeed not true. A CEO of ExxonMobil would definitely have better information on ExxonMobil stocks than a doctor who holds ExxonMobil stocks. As a CEO the individual is exposed to internal information that would enable him to make better decisions on choosing stocks and taking precautionary steps. For example, in the recent oil price drop, the CEO of ExxonMobil would know that his stocks are getting riskier, even before Standard & Poor releases a statement to the general public - The Financial Times on 2/2/2015 “ExxonMobil’s triple-A rating under threat.” With different information available, different actions will be taken, thus not all investors will be holding identical portfolios anymore. This causes another assumption, investors have homogenous expectations, to be rejected in this real

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