Free Economics Dissertations - All Investors Face The Same Efficient Frontier
As a result of the above assumptions, the following conclusions were arrived at which highlighted drawbacks inherent in the model:
All investors face the same efficient frontier of risky assets. As a result, all investors combine the identical tangent portfolio with the risk-free asset to obtain their optimal portfolio
This tangent portfolio is the market portfolio of all risky assets. Every asset is represented in proportion to its capitalisation relative to the total market capitalisation. So all investors combine two funds: the risk-free asset and the most diversified portfolio possible, the market portfolio.
The CAPM has been one of the most widely tested models of all time. Empirically CAPM held quite well in the early years of the model. Since then more and more anomalies have been discovered.
A bigger problem to CAPM advocate was voiced by Roll (1976) who claimed that the market portfolio was not measurable and thus CAPM could never truly be tested. A possible deathblow to CAPM was FAMA-FRENCH (1992) that concluded when size and the market to book value are included in the model, Beta becomes insignificant. Finally the joint hypothesis problem is also a problem in the testing of any market model. This is the idea that a test is simultaneously testing both the market and the model. Because of these difficulties, we will never be able to say definitively whether CAPM is correct or not.
Roll criticised the usefulness of the model because of its dependence on a market portfolio of risky assets. He contended that such a portfolio was not currently available. He further highlighted that when CAPM is used to evaluate portfolio performance it is necessary to select a proxy for the market portfolio as a benchmark for performance. Following the above criticisms, an alternative asset pricing theory developed which was considered to be reasonably intuitive and required limited assumptions. Thus in the early 1970s Arbitrage Pricing Theory emerged which was developed by Ross as a response to the shortcomings of CAPM.
Conclusion
From the preceding paragraphs it can be concluded that CAPM has been an influential model in asset pricing theory as it has led the way to the development of other sophisticated multi-variate models like Arbitrage Pricing Theory. It would be fair to say that CAPM has laid the foundation to understand the asset returns better and had provided direction to understanding and analysing the theory on asset returns. Thus the contribution of CAPM to finance and portfolio management is rather significant.
BIBLIOGRAPHY
Copeland, Thomas, Weston, J, and Shastri, Kuldeep, Financial Theory and Corporate Policy, (2004), Addison Wesley
Cuthbertson, Keith, Quantitative Financial Economics, (2000), Wiley
DeFusco, Richard, A., McLeavey, Dennis W., Pinto, Jerald E., and Runkle, David E.
Dissertations - Free Economics Dissertations
