Theoretical limitations of the CAPM Essay Example | Topics and Well Written Essays - 1750 words

Theoretical limitations of the CAPM - Essay Example d deviation of the returns on security I, E(RM) denotes the expected return on the market portfolio; o (RM) denotes the standard deviation of the returns on the market portfolio; and RF denotes the risk-free rate of return. A) Calculate (beta) for each of the following: i) Security A Beta = 0.1-0.04 0.2- 0.04 = 0.06/0.16 =0.375 ii) Security B Beta = 0.1-0.04 0.7-0.04 =0.0457 b. According to the Capital Asset Pricing model (CAPM), what are the expected returns for securities of A and B? We use the CAPM equation Ki = Krf + bi(Km - Krf) Where: Ki = the required return for the individual security Krf = the risk-free rate of return bi = the beta of the individual security Km = the expected return on the market portfolio (Km - Krf) is called the market risk premium KA = 0.04 + 0.375 (0.3) = 0.1525 For B KB =0.04 + 0.0457 (0.7) = 0.07199 c) Write down an expression for the security market line. Draw a sketch of the security market line, and indicate the positions of securities A and B on th is line. Explain briefly how you would interpret the security market line Ki = Krf + bi(Km - Krf) Ki = 0.004 +0.375 (0.3) Ki = Krf + bi(Km - Krf) Ki = 0.004 +0.375 (0.7) E(Ri) B Undervalued Overvalued RM 0.5A 0 1 The assets above are undervalued because they reflect a high return. d. Write down expressions for the characteristic lines for securities A and B. Draw sketches of the characteristic lines for securities A and B. Explain briefly how you would interpret the characteristic lines. E(Ri) B Undervalued Overvalued RM 0.5A 0 1 3. This question refers to Figure 1. a) In the Capital Asset Pricing Model (CAPM), what are the values of ((betai) for securities A, B and C? A= 0.06 B= 0.08 C= 0.10 b) What are residual variances for securities A, B and C A=0.7 B= 0.6 C= 0.8 c) With reference to... Due to the market portfolio’s nature of diverse investments opportunities, which in some cases are not observable, investors, use stock indexes as a proxy. This leads to inaccurate inferences about the soundness of CAPM. According to, CAPM assumes that, only two dates exists for an investor to undertake transactions such that, no extra time left to re-balance and use portfolios repeatedly. Moreover, it is normal that, diversification cannot remove systematic risk proceeds on all securities attributed to the market portfolio proceeds. This is a pure contrast to the CAPM’s assumption that investors should consider systematic risks because they can be eliminated through diversification. In conclusion, the extent of CAPM model’s limitations are bound on three primary aspects, which include the investors’ preferences on investment portfolios and investment aptitudes in relation to the investment outlay, which influences decision making on the type of investment to be considered. Secondly, the aspect of diversification: Diversification does not remove systematic risk returns on all securities attributed to market portfolio return. This is in contrast with the CAPM’s assumption that investors should consider systematic risks because diversification can purge them.