Capital Asset Pricing Model and Its Assumptions

CAPM is the word which is used in financial markets, the full form of CAPM is Capital Asset Pricing Model also known as  is one which establishes the relationship between the required rate of return of a security and its systematic risk also known as risk which is not diversification. It can be calculated as – Risk free rate + Beta of the Security(Market Return – Risk free rate). So for example if we know the risk free rate of return is 5 percent and beta of security is 2 and excepted market return is 10 percent then we can compute the excepted return of stock will be 15 percent which can be calculated as 5 + 2(10-5). Capital asset pricing model is based on certain assumptions, lets look at some of the assumptions of CAPM

Assumptions of Capital Asset Pricing Model

Risk Averse Investors

Investors are risk averse as well as rational and use standard deviation and expected rate of return for measuring the risk and return for their portfolios. Hence higher the risk of a portfolio higher will be the return excepted by the investors.

Time Horizon of the Investors

Investors make their investment decision based on a single period horizon rather than multiple period horizons. Also taxes do not affect the buying choice of the investors.

Low Transaction Costs

Transactions costs in the financial markets are assumed to be very low and also assets can be bought and sold in any division desired by the investor. Hence investors can lend and borrow unlimited amount of money at the risk free rate of interest prevailing in the market.

Availability of Information

It assumes that all information is available to all investors at the same time.

Hence from the above one can see that CAPM is based on assumptions which cannot be possible in real world but still it has wide applications in security market and hence it is very important concept as far as stock markets are concerned.

2 comments… add one
  • Tatenda Madimutsa

    Thank you. It was so helpful.

Leave a Comment

Related pages

define privatisationconglomerate organizational structuremeaning of discounting of billsadvantages of junk bondshow to fill withdrawal slipdisadvantage of merger and acquisitionadvantages and disadvantages of social media advertisingdisadvantages of market penetrationwhat is an autocratic leadershipdifference between a finance lease and an operating leasenormal good definition economicsdifference between consignor and consigneeadvantages and disadvantages of international monetary systemsouth africa mixed economy systemdirect and indirect quotes in foreign exchange marketunclaimed dividendpricing strategies skimmingexample of elastic goodssalary received journal entrydeflation advantages and disadvantagesincome effect substitution effectfull form fdidescribe the limitations of the barter systemdifference between a debtor and a creditorlimitation of financial accountinginternational trade disadvantagesunearned revenue in balance sheetdefine durable gooddifference between overdraft and term loanfactoring advantagesexample of congeneric mergerskim pricing strategywage push inflationbenefits of jit inventoryeconomic growth advantages and disadvantagesprepaid rent journal entryexamples of liability accountsconsignee consignor meaningincome effect and substitution effect examplesadvantages and disadvantages of debit card and credit cardbarter system in economicsinfosys kpoabsolute advantage formulaunsystematic definitionthe difference between accounts payable and accounts receivabledifference between job costing and process costingindirect currency quoteprice skimming examples companyfull form of tallyprivatelizationcash flow and fund flowfull meaning of fdiwhat is the difference between complementary and complimentaryhigher education advantages and disadvantagesdifferent types of profitability ratiosipo full formmeaning of advantage in hindidisadvantages of globalisationbenefits of absorption costingdisadvantages of centrally planned economyadvantages and disadvantages of cost plus pricingdefine securitizationunqualified report auditpayback method definitionprogressive tax advantagesexamples of substitution effectcompanies that are monopolistic competitiondemat account benefitszero based budgeting advantageswhat are the advantages and disadvantages of decentralizationaccelerated method of depreciation