# What are the key assumptions of the CAPM?

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What are the key assumptions of the CAPM? |

Explanation

References

1. Assumptions of capital asset pricing model. (2018, September 21). Accountlearning | Contents for Management Studies |. https://accountlearning.com/assumptions-of-capital-asset-pricing-model/

2. CAPM: Assumptions and limitations | Securities | Financial economics. (2017, December 15). Economics Discussion. https://www.economicsdiscussion.net/portfolio-management/capm/capm-assumptions-and-limitations-securities-financial-economics/29904

Answer

Answer

1. Investors who are wary of taking risks

Investors are risk averse by nature, and diversification is needed to mitigate their risk.

2. Maximizing the value of one's final capital

Rather than maximizing wealth or return, an investor seeks to maximize the utility of his assets. The expression 'utility' refers to the variety of personal interests. Each increment of wealth is enjoyed less than the previous since each increment is less important in meeting the individual's basic needs. As a result, wealth is the best example of diminishing marginal utility.

Utility functions come in a variety of shapes and sizes. Those with rising marginal utility for capital are among the investors who prefer higher risks. In such cases, each increase in wealth motivates the individual to accumulate more wealth.Every increase in wealth is equally appealing to a risk-averse investor. To put it another way, each increment will serve the same purpose for him.

3. Investment decisions based on risk and return

Investing decisions are made based on risk and return. The variance and mean of portfolio returns are used to calculate risk and return. CAPM assumes that rational investors save their unsystematic risk, which is diversifiable risk. However, only the systemic danger remains, which differs with the security's Beta.

Some investors only use the beta to calculate risk, while others use both the beta and the variance of returns to determine reward. CAPM provides a set of effective frontlines because people's expectations of risk and reward differ.

4. Risk and return targets that are similar

Both investors have similar risk and return goals. In other words, all investors' risk and return estimates are the same. When investors' expectations vary, the mean and variance projections provide different forecasts.

As a consequence, there will be a plethora of efficient frontiers, each with its own efficient portfolio. As a result of differing tastes, the price of an asset can vary for different investors.

5. Time horizons that are identical

The CAPM is built on the premise that all investors have the same time horizon. This theory is based on the idea that investors purchase all of the assets in their portfolios at once and sell them at some unknown but common point in the future. This statement also means that investors put together portfolios in order to accumulate wealth at a single common terminal cost.

A single duration model can be built using this single common horizon. Since investors are short-term speculators, this presumption is extremely irrational. Furthermore, the horizon is selected based on an asset's characteristics.

As a result, investors' time horizons differ, and their stock valuation expectations fluctuate even though expected earnings remain constant. Investors typically use continuous time models instead of single phase models, as if they were making a sequence of reinvestment.

6. Unrestricted access to all details

One of the main assumptions of the CAPM is that investors have free and unrestricted access to all available information. If only a few investors have access to special information that is not widely accessible to anyone, the markets are not considered successful.

To put it another way, if all of the available knowledge has not reached everybody, drawing a common efficient frontier line would be difficult.

7. There is a risk-free commodity, and borrowing and lending at the risk-free rate is not limited.

The CAPM relies heavily on this premise. The risk-free asset is needed to simplify Markowitz's theory's complex pairwise covariance. The risk-free asset simplifies the MPT's curved efficient frontier to the CAPM's linear efficient frontier.

As a result, investors would be less concerned with individual asset characteristics.

The risk is either reduced or increased by adding a portion of risk-free assets to the portfolio and borrowing the additional funds required at a risk-free rate.

8. There are no taxes or transaction fees to worry about.

According to Roll, either a risk-free asset or a portfolio of short-sold securities must be present. The capital Market Line (CML) would then be the only line that is straight. When there are no risk-free assets available, the investor is unable to construct a risk-free proxy asset. As a result, the capital market line would no longer be linear, and there would no longer be a clear linear relationship between risk and return.

9. Properties have a fixed total supply and are marketable and divisible.

The total asset quantity is fixed, and all assets are marketable, according to this assumption. Unmarketable assets have, however, been used in models that are more complex than the simple CAPM.