Question

what are the assumptions in the capital asset pricing model?

Thanks

Answer 1

Assumptions of CAPM:

• Investors are risk averse, utility maximizing, rational individuals

Risk averse means investors need to be compensated for taking on risk. Utility maximization means that investors always want more return and wealth (i.e investors are never satisfied). Investors are understood to be rational in that correctly evaluate all scenarios rationally while making a decision.

• Market are frictionless, including no transaction costs and no taxes

Frictionless markets imply that markets do not have transaction costs, taxes , or any restrictions on short selling. What this assumption also implies is that borrowing and lending can be done at the risk free rate.

• Investors plan for the same single holding period

The assumption of a single period is applied for convenience because working with multi-period models is more difficult. A single-period model, however, does not allow learning to occur, and bad decisions can persist.

• Investors have homogenous expectations and beliefs

All investors analyze securities in the same wayand thus arrive at the same valuations. Hence, they will generate the same portfolio which is also called the market portfolio.

• All investments are infinitely divisible

This assumption implies that an individual can invest as little or as much as he or she wishes in an asset.

• Investors are price takers

No investor is large enough to influence the asset prices.