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Assumptions of Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) has some assumptions upon which it is built. Here are the five most influential assumptions of CAPM −
The investors are risk-averse
CAPM deals with risk-averse investors who do not want to take the risk, yet want to earn the most from their portfolios. Diversification is needed to provide these investors more returns.
Choice on the basis of risks and returns
CAPM states that Investors make investment decisions based on risk and return. The return and risk are calculated by the variance and the mean of the portfolio. CAPM reinstates that rational investors discard their diversifiable risks or unsystematic risks. Only the systematic that varies with the Beta of the security remains.
There are differences among investors regarding the use of Beta. Some investors use Beta only to measure the risk while others use both beta and variance of returns. CAPM provides a series of efficient frontlines because individuals have different perceptions towards risk and reward.
Similar expectations of risk and return
The expectations of risk and return of all investors are the same. In other words, all investors’ anticipation of risk and returns are the same. When the expectations differ, the anticipated mean and variance forecasts differ significantly.
Due to this, innumerable efficient frontiers are possible. Moreover, the efficient portfolio of each asset will be different from others. Varying preferences also mean that the price of an asset will be different for different investors.
Free access to all available information
One of the important assumptions is that all investors have free access to all the required and available information free of cost. If some investors alone are able to have access to special information, that is limited to only some investors, then the markets are regarded inefficient. In other words, it is difficult to draw a common efficient frontier line if the available information is not accessible to all.
There is a risk-free asset and there is no restriction on borrowing and lending at the risk-free rate
CAPM assumes the availability of risk-free assets to simplify the complex and paired covariance of Markowitz’s theory. The risk-free asset leads to the curved efficient frontier of MPT and makes the linear efficient frontier of the CAPM simple.
As a result, the investors would not concentrate on the qualities of individual assets. By adding a portion of risk-free assets and borrowing the additional investments needed at a risk-free rate, the risk can be either decreased or increased.
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