Question

What are the weaknesses of CAPM?

What are the weaknesses of CAPM?

Homework Answers

Answer #1

Weakness of CAPM

  • Risk-free rate - The rate used in CAPM is used as short-term government yield which is itself subject to daily change while in itself creates volatility which is not captured in the CAPM model
  • Market return - The market return is a subjective term and which index consisting of how many stocks should be used as a reference is vague. Also, whether short-term market returns should be considered or long term market returns should be considered is subjective to the user.
  • The assumption to borrow at the risk-free rate is flawed as no borrower carries zero risk and hence will never be able to raise debt at the risk-free rate of interest.
  • Beta in itself is not constant and is subject to market returns as well as the stock returns. Hence, zeroing down on a single required rate of return is an absurd assumption which leads to flawed results.
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