Question

Explain the CAPM. [hint: we need to discuss systematic and unsystematic risks,

diversification, assumptions CAPM makes, SML line, the model, things CAPM can't

explain, etc. ]

Answer 1

Capital Asset pricing model is used to find out the expected return of the portfolio.

It considers the the systematic risk related to the portfolio and it also considered the risk-free rate and assign the market premium to the systematic risk in order to find out the expected rate of return of a Portfolio.

Capital Asset pricing model is based upon various options and that will include that risk free rate is actually risk free,investors are always looking for diversity portfolio and investors are rational in nature and there would be always be a premium for systematic risk in the market.

unsystematic risk will not be taken for calculation when calculating Capital Asset pricing model because diversification eliminates unsystematic risk.

CAPM return= Rf+ Beta*risk premium

This model have various limitations also because the risk free rate is actually not risk free in the real world and investors are not rational and they are not always looking for diversification.another limitation associated with Capital Asset pricing model is that beta is neither consistent in nature.