Question

Elaborate the FOUR (4) assumptions of CAPM model in measuring risk and
return with a suitable example.

Answer 1

CAPM = Capital Asset Pricing Model

Listing 4 assumptions of CAPm here with examples

1. All Investors are Risk averse - Which means that the investors ask for higher required rate of return if the risk (Beta or standard deviation) is higher of a stock.

Example :

Let the Risk free rate be = 3% and Market risk premium = 5%

If a stock has a beta of 1.5 the required rate of return is 10.5% and another stock with beta of 2, the required rate of return will be 13% (higher)

CAPM required return = Risk free rate + Beta (market risk premium)

= 3% + 1.5(5%)

= 10.5%

If beta is 2 the reuqired return is 13% (3% + 2(5%))

2. All Investors will choose stocks to invest based on risk and return

Example :

(Let Standard deviation be risk)

Suppose there are two stocks, one with 8% expected return and standard deviation is 10%, another stock with 12% expected return and standard deviation is 10%. In this case, he chooses second stock as it gives higher return with same risk (standard deviation).

3. All investors have similar expectations of risk and return - This means that all the investors will have same perspective of a stock and their expectations will be same.

Example :

All the investors will see a stock (suppose A) in the same way in terms of risk and return. Which means that every investor will have same expected return and risk from that stock.

4. No restriction on borrowing and lending at risk free rate - The CAPM assumes that all the investors has easy access to risk free rate. They can borrow and lend at risk free rate without any restrictions.

Example :

Suppose there exists a Risk free asset (with nill or minimal risk) and the return on such risk free stock is 3%. (In General this means a Government bond). An investor can earn at 3% by investing in these risk free assets and this investment opportunity is available to all investors without any restrictions.