Question

Do you agree with three assumptions made in CAPM? Please take a closer look at those three, and think about the outcomes when one of those assumptions are changed or modified. Could you describe it to us how the required return of each assets will be different, as well as portfolio efficiency, CML and SML?

Answer 1

One of the major assumptions which is made in Capital Asset pricing model is complete diversification of investor.

Capital Asset pricing model assumes that all the investors are already diversified so there is no scope for further diversification and only systematic risk is existing in the environment because unsystematic risk is completely eliminated for complete diversification of Investors.

Required rate of return of various assets are going to change dramatically if you eliminate the complete diversification of investor because then every investor will be having his risk represent in the terms of total risk which could be a combination of both systematic and unsystematic risk and it would mean to higher required rate of return for these similar given risk because there will be an element of unsystematic risk associated with the portfolio.

There will be a different representation of the assets on Capital Asset pricing line as well as security market line as well because these will not be completely efficient as they are not diversified as well

it will also impact the portfolio efficiency so it will lead to less efficient portfolio due to presence of unsystematic risk into it.