comments and criticism of CAPM essays

comments and criticism of CAPM essays Underlying assumptions and limitations of the CAPM The CAPM is a mathematical model, and like any model it is merely a representation of reality. All models are constructed from a set of underlying assumptions about the real world, they inevitably have their limitations. The CAPM is built on the following set of assumptions and limitations. Historic data. CAPM is a future- oriented model yet it essentially relies on historic data to predict future returns. Betas for example are calculated using historic data, consequently they may or may not be appropriate predictors of the variability or risk of future returns. The CAPM is not a deterministic model, the required returns suggested by the model can only be viewed as approximations. investor expectations and judgements. The model includes the expectations and subjective judgements of investors about future asset or security returns and these are very difficult to quantify. In addition the model also assumes that investor expectations and judgments are homogeneous i.e. identical. If investors have heterogeneous (i.e. varied) expectations about future returns they will essentially have different SMLs rather than a common SML as implied by the model. A perfect capital market. CAPM assumes an efficient or perfect capital market. An efficient capital market is one where all securities and assets are always correctly priced and where it is not possible to outperform the market consistently expect by luck. An efficient capital market implies that there are many small investors (all are price takers), all of whom are rational and risk averse; they each posses the same information and the same future expectations about securities. It also assumes that in the financial markets there are no transaction costs, no taxes and no limitations on investments. Investors fully diversified. The CAPM also assumes that investors are fully diversified. In practice many investors, particularly sm...