Capital Asset Pricing Model (CAPM)
Capital Asset Pricing Model (CAPM) shows the relationship between the expected return and systematic risk. As far, it is known that the expected return means the mean or average of the return and systematic risk is the risk that cannot be diversified.
Limitations of the Capital Asset Pricing Model (CAPM)
- Difficult to Measure Risk
- Unrealistic Assumptions
- Betas Remain Unstable Over Time
- Validity Difficulties
Difficult to Measure Risk
The most significant limitation of CAPM is to calculate the risk as well as measure of risk in the equation method because CAPM is only derived to measure the expected rate of return by using the risk free rate, market return and beta coefficient where the beta coefficient is derived by the means of volatile single stock’s price. In that case, the measurement of risk is difficult as CAPM submits a quantitative and logical approach to estimate the risk.
There are some assumptions of Capital asset pricing model those are far from reality. For example, In CAPM approach there is a risk-free rate consideration which defines government security is risk-free. From, investor point of view it could be said that an investor is risk-free but if we think about the inflation in an economy where the CAPM approach does not consider the inflation where inflation is the most important factor of the economy.
So, in that case, it will be so difficult to find a risk free security where inflation is a vital factor. There is an assumption of lending and borrowing rates which will be equal but in real market scenario this is totally wrong, there must have differences. Again, the concept of diversified portfolios does not apply is CAPM, but the real market scenario is different; by holding a diversified portfolio it could be possible to earn more return. Under this above consideration, the Capital Asset Pricing Model (CAPM) approach is totally unrealistic to the real market.
Betas Remain Unstable Over Time
In the measurement of risk, the stability of the beta coefficient is important otherwise the future risk measurement will be a problem. It is practiced to use the historical data to measure the risks but beta calculation by using historical data does not remain stable. That means beta from historical data is the poor indicator. Though the Capital Asset Pricing Model (CAPM) shows the risk-return relationship the problem comes forward when the risk is not captured by the beta coefficient alone as it uses the historical data.
It has already been described that some assumptions are not relevant to the real market that’s why there are some critics. The empirical validity of the capital asset pricing model is the ability of the beta coefficient to estimate the risk inherent though there is a correlation between beta and the expected return. There is a result that the Capital Asset Pricing Model (CAPM) has a conceptual problem in the validity of the beta coefficient. The conflict arises when the studies do not find any relationship between betas and returns, rather got the relationship between returns and book value.
The Extent to which the Multifactor Model Overcome the Above Limitations of CAPM
- MULTIFACTOR model is based on many multi factors where the expected return is calculated by considering different factors that are very real with the real market. The fact of Inflation that is not considered in the CAPM, in case of multifactor model Inflation is another important factor without which the calculation of risk or return will not be valid as well justifiable. And the factor like inflation, deflation, time value of money this is considered in the multi-factor model that must affect the stock price movement more largely and specifically.
- MULTIFACTOR model is based on the arbitrage pricing theory that provides a fair expected rate of return on the risky asset as the assumption of market equilibrium is considered here.
- MULTIFACTOR based Arbitrage Pricing Theory model provides the importance on the aspect of covariance as covariance illustrates the variance between risk and the expected return. In that case, CAPM was only reliable to the measurement of expected return.
- In the aspect of multi-period cases, the model of APT is the response to MULTI-FACTOR model works better where CAPM was not suitable that assumes the single period which is not relevant to the real market.
- In the evaluation of the cost of capital, MULTI-FACTOR model provides a satisfactory result where CAPM on defining the single model of the cost of equity.
- In the evaluation of capital budgeting MULTIFACTOR model is used to get the acceptation rejection decision accurately.