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Disadvantage 0f CAPM:

Every coin has two sides; congenial and adversity. CAPM also has some disadvantages too as
like following:
-The model assumes that all active and potential shareholders have access to the
same information and agree about the risk and expected return of all assets
(homogeneous expectations assumption.
-The model assumes that the probability beliefs of active and potential shareholders
match the true distribution of returns. A different possibility is that active and
potential shareholders' expectations are biased, causing market prices to be
informationally inefficient.
-The model assumes that given a certain expected return, active and potential
shareholders will prefer lower risk (lower variance) to higher risk and conversely
given a certain level of risk will prefer higher returns to lower ones. It does not allow
for active and potential shareholders who will accept lower returns for higher risk.
-The model assumes that there are no taxes or transaction costs, although this
assumption may be relaxed with more complicated versions of the model.
-The model assumes economic agents optimize over a short-term horizon, and in
fact investors with longer-term outlooks would optimally choose long-term inflationlinked bonds instead of short-term rates as this would be more risk-free asset to
such an agent.
-CAPM assumes that all active and potential shareholders will consider all of their
assets and optimize one portfolio. This is in sharp contradiction with portfolios that
are held by individual shareholders: humans tend to have fragmented portfolios or,
rather, multiple portfolios: for each goal one portfolio.
-The model assumes that the variance of returns is an adequate measurement of
risk. This would be implied by the assumption that returns are normally distributed,
or indeed are distributed in any two-parameter way, but for general return
distributions other risk measures will reflect the active and potential shareholders'
preferences more adequately.

Application of CAPM:
We can use CAPM to decide what price you should pay for a particular stock . CAPM is most often
used to determine what the fair price of an investment should be.
With its insight into the financial markets pricing of securities and the determination of expected returns,
CAPM has clear applications in investment management. Its use in this field has advanced to a level of

sophistication far beyond the scope of this introductory exposition. CAPM has an important application in
corporate finance as well. The finance literature defines the cost of equity as the expected return on a
companys stock. The stocks expected return is the shareholders opportunity cost of the equity funds
employed by the company.
CAPM can be best explained by looking at an example.
Assume the following for Asset XYZ:
rrf = 3%
rm = 10%
Ba = 0.75
By using CAPM, we calculate that you should demand the following rate of return to invest in Asset
XYZ: ra = 0.03 + [0.75 * (0.10 - 0.03)] = 0.0825 = 8.25%

"APPLYING CAPM"
The extensive use of the Capital Asset Pricing Model (CAPM), assists in isolating the
target sector where potential opportunities appear. For example: companies with
small capitalization often have increased price fluctuation, while having both the
highest expected return and risk. In between these two extremes lie corporate
stocks and bonds. Attempt is made to employ a method that determines when
individual stocks deviate from this important relationship. When stocks show high
potential return but lower than expected risk, they are deemed as "undervalued" or
"discounted". The philosophy is based on value investing which aims to find good
companies, run by high quality management with low market prices, relative to
current values. Investment managers select sound companies that are selling at a
low Price/Earnings Multiple with little or no debt.
For example, if an investor can make 8% p.a. by investing in riskless RBI bonds,
then he/she will not settle for less than this as an expected return for investing in a
riskier asset. Beta is the component which varies from one stock to another. For
example, financial stocks are extremely sensitive to interest rates, and with every
movement in either US Fed Reserve/Reserve Bank of India/Bank of England/Bank of
Japan monetary policy, they would experience huge fluctuations. Investments such
as financial sector stocks which add more risk to the market portfolio will have
higher betas than those which add less risk.
Assuming a risk-free return of 8%, beta of 1.78 for IFCI and a risk premium of 7%,
we find the expected return for IFCI stock as
Expected Return = 8% +1.78(7) = 8% + 12.46 = 20.46 %

The rationale of the CAPM can be simplified as follows. Investors can eliminate some
sorts Of risk known as residual risk or alpha by holding a diversified portfolio of
assets. These alpha risks are specific to an individual asset, for example, the risk
that a companys managers will turn out to be no good. Some risks, such as that of
a global recession; cannot be eliminated through diversification.

Conclusion:
The capital asset pricing model is by no means a perfect theory. But the spirit of CAPM is correct . The
capital asset pricing model (CAPM) is an idealized portrayal of how financial markets
price securities and thereby determine expected returns on capital investments.
The model provides a methodology for quantifying risk and translating that risk into
estimates of expected return on equity.

References:
-Kothari, S. P., Jay Shanken and Richard G. Sloan. 1995. Another Look at the Cross-Section
of Expected Stock Returns.

-Journal of Finance. 50:1, pp. 185224.

-Elton, Edwin J., Martin J. Gruber, Sanjiv Das and Matt Hlavka.1993.Efficiency with Costly Information: A Reinterpretation of
Evidence from Managed Portfolios.Review of Financial Studies . 6:1, pp. 122

-Fama, Eugene F. and Kenneth R. French.1993.Common Risk Factors in the Returns onStocks and Bonds.Journal of Financial
Economics.33:1, pp. 356
-Bhandari, Laxmi Chand.1988. Debt/Equity Ratio and Expected Common Stock Returns:
Empirical Evidence.Journal of Finance.43:2,pp. 50728