Question

“The Capital Asset Pricing Model [CAPM] assumes that the stock market is dominated by well-diversified investors who are concerned with specific risk. “ Do you agree with the following statement? And explain why.

Answer 1

I do not completely agree with the following statement because Capital Asset pricing model is only discounting the systematic risk associated with the investment and it assumes that all the investors in the market are already well diversified which is a wrong assumption because investors are never well-diversified and they are always exposed to unsystematic risk and hence this assumption of Capital Asset pricing model is not practical in the real world because large number of investors are highly exposed to firm a specific risk because they are not well diversified through exposure into various securities.

Capital Asset pricing model will also assuming that expected return for non systematic risk will be zero in the portfolio which is completely not in accordance with practical scenario, because there is a large number of investors who had not completely hedged to firm specific risk and they are also concerned about firm specific and unsystematic risk as well and they are not just focused about a specific risk or systematic risk so it can be said that the given statement regarding Capital Asset pricing model is not completely in accordance with the practical world because Capital Asset pricing model will always be assuming that there is just systematic factors which are causing difference in return of the portfolio of the investor and they are leading to changes in expected rate of return of the investor because these specific risk are influencing the the risk of the investor in the market and hence it is not to be completely assumed in accordance with the practical world because in practical world, large number of investor are highly exposed to unsystematic risk so I do not agree with the statement regarding Capital Asset pricing model.