Question

1. Which of the following is an assumption of CAPM?

1. The price of the asset is driven by investors’ trading actions.
2. All the investors have the same expectations of the market.
3. Investors’ wealth in the next period depends on the performance of their portfolios during the current period.
4. Investors pay small amount of transaction costs.

Answer 1

The correct answer is B. All the investors have the same expectations of the market.

CAPM or Capital Asset Pricing model states that risk can be decomposed into Systematic and Unsystematic risk. As Unsystematic risk is diversifiable the only relevant risk is systematic risk captured by beta.

Assumptions of CAPM

• Investors are rationale
• Investors have uniform single period investment horizon
• Investors have homogeneous expectations
• Markets are perfectly competitive
• Markets are in equilibrium.

The Investors invest in the most diversified portfolio i.e. market portfolio and combine that with Risk free rate borrowing or lending. In short, all investors lie along the capital market line and enjoy the highest sharp ratio.

CAPM helps in calculating the Required Rate of Return for an investor. It is the minimum return that an investor would want from his investment.

The formula for calculating Re or Required rate of return is

As per Capital Asset Pricing Model (CAPM)

Re = Rf + (Rm-Rf) β

Where Re = Required rate of return

Rf = Risk free rate of return

Rm – Market Return or Expected Return on Market

β – Beta of the stock