Question

Explain the critical assumptions that underpin the Capital asset pricing model (CAPM).

(500 WORDS)

Answer 1

_{Explain the critical assumptions that underpin the Capital asset pricing model (CAPM).}

The CAPM is based on the following assumptions.

I. Risk-averse investors

The investors are basically risk-averse and diversification is necessary to reduce their risks.

II. Maximizing the utility of terminal wealth

An investor aims at maximizing the utility of his wealth rather than the wealth or return. The term ‘Utility’ describes the differences in individual preferences. Each increment of wealth is enjoyed less than the last as each increment is less important in satisfying the basic needs of the individual. Thus, the diminishing marginal utility is most applicable to wealth.

III. Choice on the basis of risk and return:

Investors make investment decisions on the basis of risk and return. Risk and return are measured by the variance and the mean of the portfolio returns. CAPM assumes that the rational investors put away their diversifiable risk, namely, unsystematic risk. But only the systematic risk remains which varies with the Beta of the security.

Some investors use the beta only to measure the risk while other investors use both beta and variance of returns as the sources of reward. As individuals have varying perceptions towards risk and reward, CAPM gives a series of efficient frontlines.

IV. Similar expectations of risk and return

All investors have similar expectations of risk and return. In other words, all investors’ estimates of risk and return are the same. When the expectations of the investors differ, the estimates of mean and variance lead to different forecasts.

As a result, there will be innumerable efficient frontiers and the efficient portfolio of each will be different from that of the others. Varying preferences also imply that the price of an asset will be different for different investors.

V. Identical time horizon

The CAPM is based on the assumption that all investors have identical time horizon. The core of this assumption is that investors buy all the assets in their portfolios at one point of time and sell them at some undefined but common point in future. This assumption further implies that investors form portfolios to achieve wealth at a single common terminal rate.

VI. Free access to all available information

One of the important assumptions of the CAPM is that investors have free access to all the available information at no cost. Supposing some investors alone are able to have access to special information which is not readily available to all, then the markets would not be regarded efficient. In other words, if the available information has not reached all, it will be difficult to draw a common efficient frontier line.

VII. There is a risk-free asset and there is no restriction on borrowing and lending at the risk-free rate

This is a very important assumption of the CAPM. The risk-free asset is essential to simplify the complex pairwise covariance of Markowitz’s theory. The risk-free asset makes the curved efficient frontier of MPT to the linear efficient frontier of the CAPM simple.

VIII. There are no taxes and transaction costs

According to Roll, there must be either a risk-free asset or a portfolio of short sold securities. Then only the capital Market Line (CML) will be straight. When there are no risk-free assets, the investor could not create a proxy risk-free asset. As a result, the capital market line would not be linear and the direct linear relationship between risk and return would not exist.

IX. Total availability of assets is fixed and assets are marketable and divisible

This assumption holds the view that the total asset quantity is fixed and all assets are marketable. However, models have been developed to include unmarketable assets which are more complex than the basic CAPM.