LIMITATIONS OF CAPM


CAPM has several weaknesses e.g.

a. It is based on some unrealistic assumptions such as:

i. Existence of Risk-free assets

ii. All assets being perfectly divisible and marketable (human capital is not divisible)

iii. Existence of homogeneous expectations about the expected returns

iv. Asset returns are normally distributed.

b. CAPM is a single period model—it looks at the end of the year return.

c. CAPM cannot be empirically tested because we cannot test investors expectations.

d. CAPM assumes that a security's required rate of return is based on only one factor (the stock market—beta). However, other factors such as relative sensitivity to inflation and dividend payout, may influence a security's return relative to those of other securities.

The Arbitrage pricing theory is designed to help overcome these weaknesses.