Answer :
The Capital Asset Pricing Model (CAPM) is a widely used financial model that explains the relationship between risk and return for individual securities. While it provides a useful framework for understanding equity returns, it may have limitations in explaining the specific dynamics observed during the COVID-19 pandemic in 2020-21.
During the pandemic, global financial markets experienced unprecedented volatility and uncertainty. CAPM assumes that returns are solely influenced by systematic risk, as measured by beta, and the risk-free rate. However, the pandemic introduced additional factors that had a significant impact on equity returns, such as government interventions, lockdown measures, and the uncertainty surrounding the duration and severity of the crisis.
CAPM does not explicitly account for these types of events and their effects on market behavior. As a result, it may not adequately capture the extreme swings and deviations from normal market conditions observed during the pandemic.
Moreover, CAPM assumes that asset returns are normally distributed, but during periods of crisis, such as the pandemic, market returns often exhibit fat tails and high kurtosis, indicating a higher likelihood of extreme events. This deviation from normality further challenges CAPM's assumptions.
While the CAPM provides a useful framework for understanding risk and return relationships, it may not fully explain equity returns during the COVID-19 pandemic in 2020-21. The unique circumstances of the crisis, such as government interventions and unprecedented uncertainty, introduced factors that were not explicitly considered in the CAPM model. To gain a more comprehensive understanding of equity returns during the pandemic, it is necessary to incorporate additional variables and models that account for the specific dynamics observed during such extraordinary events.
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