Market Efficiency and Limitations of CAPM

Running head: MARKET EFFICIENCY AND CAPM
Market Efficiency and Limitations of CAPM
Name of the Student:
Name of the University:
Author’s Note:

MARKET EFFICIENCY AND CAPM
CAPM and Market Efficiency “Zainab”
The pricing model can be understood primarily by two theories namely Random Walk theory
and Market Efficiency. The former, that is, the Random Walk model elucidates the formation of
price through absorption of information and even through movements in price is random
irrespective of previous trends in the market. The latter, that is, market efficiency, is defined
when the prices are determined through market forces of demand and supply such that the
demand holds full and accurate information.
Nevertheless, in reality, the information cannot be free-flowing, complete or accurate due to
other factors. The trends change the pattern of price and involves technical analysis as given by
applicability of Dow theory. This can be explained further that if the information is not free-
flowing, complete or accurate, then the market prices are around the shares intrinsic values but
are not worth the value.
The actual pricing of shares is examined by majorly financial ratios like Earning potential of the
share (EPS), P/E ratio, Dividend Yield and other ratios that determine the trend of price and is
able to forecast whether the share is under-priced or overpriced. As, a result, based on the price
determination, the investor either sells the overpriced share or buys the under-priced shar;
ascertaining that the random walk theory is not proved and the market is not efficient. However,
a CAPM is valid and based on assumptions if there is free play of market forces, competition and
market efficiency in the market.
The capital asset pricing model, determines the efficient frontier for the investor by escaping the
company specific risk, while with the use of model of Markowitz, the efficient portfolio can be
derived through efficiency frontier line and Capital Market Line for an individual investor. The
efficient portfolio, herein, not only maximizes the return for the given amount of risk but even
minimizes the risk for given level of return. Yet, efficient portfolio is constructed under the
portfolio theory with the risk-return analysis.
On the other hand, in modern portfolio theory, the risk measure is given by the Beta coefficient,
from the risk of expected returns in CAPM. The beta coefficient is the company’s specific to that
of the market risk. Also, it is depicted through slope of CML. As a representation, the higher
beta scrips are aggressive for companies like Reliance and TELCO as they give higher return and