Explain the Capital Asset Pricing Model (CAPM).

Expert Solution

What is CAPM?

1. Theory of asset price determination for firms.

2. Based on portfolio theory and Market Model.

3. The only thing that matters is Beta (co-movement with the market).

4. Alternative to valuation theory for individual firms.

Assumptions of CAPM : -

1. Many investors who are all price takers.

2. Financial markets are competitive.

3. Returns provide full summary of investment opportunities.

4. All investors plan to invest over the same time horizon.

5. Abstracts from heterogeneity in investors (i.e., risk averse have different time preferences than the risk tolerant).

6. Helps address any deviations from CER model.

7. No distortionary taxes or transaction costs.

8. Clearly a false assumption (debt vs. equity).

9. All investors can borrow/lend at same risk free rate.

10. But we can consider Zero-Beta version of CAPM with short-sales.

CAPM Formula : -

Expected Return = Risk free rate + (Beta x Market risk premium)

jeff jeffy answered 5 months ago

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