Assumptions of Capital Asset Pricing Model (CAPM)
The use of CAPM and its assumptions can be helpful in estimating the expected return of a stock. The basic assumptions of CAPM include:
- The model aims to maximize economic utilities.
- The results are risk-averse and rational.
- The results are price takers. This implies that they cannot influence prices.
- The model can lend and borrow unlimited amounts under the risk-free rate of interest.
- The model presumes that all info is available at the same time to all investors.
- The model trades without taxation or transaction costs.
- The model deals with securities all of which are highly divisible into small parcels.
- The results are widely diversified across a range of investments.
The capital asset pricing model (CAPM) has the following limitations
- Unrealistic assumptions: The capital asset pricing model is based on a number of assumptions that are far from reality. For example, it is very difficult to find risk free security. A short term highly liquid government security is considered risk-free security.
It is unlikely that the government will default, but inflation causes uncertain about the real rate of return. The assumption of the equality of the lending and borrowing rates is also not correct. In practice, these rates differ. Further investors may not hold highly diversified portfolios or the market indices may not well diversify.
- Difficult to validity: Most of the assumptions may not be very critical for their practical validity. Therefore is the empirical validity of the capital asset pricing model. Need to establish that the beta is able to measure the risk of a security and that there is a significant correlation between beta and the expected return. The empirical results have given mixed results. The earlier tests showed that there was a positive relation between returns and betas.
- Betas do not remain stable over time: Stability of beta, beta is a measure of a securities future risk. But investors do not further data to estimate beta. What they have are past data about the share prices and the market portfolio.
Thus, they can only estimate beta based on historical data. Investors can use historical beta as the measure of future risk only if it is stable over time. Most research has shown that the betas of individual securities are not stable over time. This implies that historical betas are poor indicators of the future risk of securities.