Limitations to CAPM
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Capm has a number of unrealistic assumptions
such as:
1-perfect capital market exists,i.e the market is efficient market (in equilibrium).
2-lending and borrowing can take place at risk free rates.
3-all investors have the same expectations about return and risk
4-capm works only when we r well diversified, only a diversied portfolio investor can use capm(unsystematic risk is not accounted for into capm)
5-risk is measured on the basis of historic returns patterns and assumption is that returns pattern will repeat in the future .
6-beta worked out from std. Dev. Of returns which are in turn measured on the basis of historic return pattern and also it is assumed that the pattern will repeat in future.
The beta is calculated from std of portfolio divided by std. Dev. Of market,and these std.dev. Are itself measured on the basis of historic patterns of returns and it is assumed that these patterns will be repeated in the future. Which itself is a not correct assumption as no one can predict the future and it is also not the case that pattern will repeat in the same proportion and same order.
Fcfc/fcfe,dvm,beta,std.dev.,ke,wacc,etc all are dependent onto the market observations,market may not be strong form efficient(as is the case in practical world),due to which the market observations will become unsatisfactory to be regarded as of an equilibrium market ,so on the basis of these market observations if we r working out any thing ,then this inefficiency of nonequilibrium market observations will built into each and every formula,analysis that we use .so efficiency or equilibrium state of market is important,otherwise the observation based on any other state of market will be builting on into itself the errors of market inefficiencies.
Other issue is how many no. Of observations to be taken? Probability analysis only works when a same thing is repeated for a number of times otherwise probability cant be used.the estimates according to probabilty might be correct only if the same thing is repeated a no. Of times
market observations shuld be of an equilibrium market
future can be predicted on the basis of historic return but with certain adjustments as to the future uncertainities should be made to historic returns pattern.
Beta should be measured frm std dev. Which are in turn worked out frm market observations of an equilibrium and efficient market.
Remember any analysis/technique dependent on market observation has a flaw that the observation may not be of an equilibrium market,efficient market.
The error of inefficiency of market will built into any analysis based onto the market observation.
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