What are the Assumptions of CAPM? Explained

Assumptions of CAPM; The Capital Asset Pricing Model (CAPM) measures the risk of security about the portfolio. It considers the required rate of return of security in the light of its contribution to total portfolio risk. CAPM enables us to be much more precise about how trade-offs between risk and return are determined in the financial markets. In CAPM the expected rate of return can also think of as a required rate of return because the market is assumed to be in equilibrium. Even though the CAPM is competent to examine the risk and return of any capital asset such as individual security, an investment project or a portfolio asset, we shall be discussing CAPM concerning risk and return of a security only. So, what is the question; What are the Assumptions of CAPM? Explained.

Here are explain What are the Assumptions of the Capital Asset Pricing Model (CAPM)?

The capital market theory is an extension of the portfolio theory of Markowitz. Also, the portfolio theory explains how rational investors should build efficient portfo­lio based on their risk-return preferences. Capital Market Asset Pricing Model (CAPM) incorporates a relationship, explaining how assets should be priced in the capital market. As Betas differ according to the market proxy, that they measure against, then in effect, CAPM, has not been and cannot test. We may recall that CAPM states that;

Return = Risk-free rate + Beta (Market Return – Risk-free rate)

A security with a zero Beta should give a risk-free return. In actual results, these zero beta returns are higher than the risk-free return indicating that there are some non-Beta risk factors or some leftover unsystematic risk. Besides, although, in the long-run, high Beta portfolios have provided larger returns than low-risk ones, in the short-run, CAPM Theory and the empirical evidence diverge strikingly; and, also, sometimes the relationship between risk and return may turn out to be negative which is contrary to CAPM Theory.

It can thus be concluded that CAPM Theory is a neat Theoretical exposition. As well as, The CML and SML are the lines reflecting the total risk and systematic risk elements in the portfolio analysis, respectively. But in the actual world, the CAPM is not in conformity with the real world risk-return trends and empirical results have not always supported the Theory at least in the short-run.

Assumptions of Capital Market Theory:

• Investors are expected to make decisions based solely on risk-return assessments.
• The purchase and sale transactions can undertake in infinitely divi­sible units.
• Investors can sell short any number of shares without limit.
• There is perfect competition and no single investor can influence prices, with no transaction costs, involved.
• Personal income tax is assumed to be zero.
• Investors can borrow/lend, the desired amount at riskless rates.

Assumptions of CAPM (Capital Asset Pricing Model):

The CAPM base on the following assumptions points.

• Risk-averse investors.
• Maximizing the utility of terminal wealth.
• The choice based on risk and return.
• Similar expectations of risk and return.
• Identical time horizon.
• Free access to all available information.
• There is a risk-free asset and there is no restriction on borrowing and lending at the risk-free rate.
• There are no taxes and transaction costs, and.
• The total availability of assets fixed and assets are marketable and divisible.

The following some key points also very helpful explaining Assumptions of CAPM:

• Investors are risk-averse and use the expected rate of return and standard deviation of return as appropriate measures of risk and return for their portfolio. In other words, the greater the perceived risk of the portfolio; also, the higher return a risk-averse investor expects to compensate for the risk.
• Investors make their decisions based on a single period horizon.
• Transaction costs are low enough to ignore and assets can be bought and sell in any quantity. As well as, the investor limits only by his wealth and the price of the asset.
• Taxes do not affect the choice of buying assets, and.
• All individuals assume that they can buy assets at the going market price; and, they all agree on the nature of the return and the risk associated with each investment.