The CAPM model attempts to capture market behavior. It is simple in concept and has real-world applicability. The portfolio theory is really a description of how rational investors should build an efficient portfolio. **Capital market theory** tells us how assets should be priced in the capital markets if, indeed, everyone behaved in the way portfolio theory suggests.

The capital asset pricing model (CAPM) is a relationship explaining how assets should be priced in the capital markets.

## What is the Capital Asset Pricing Model (CAPM)?

The capital asset pricing model is based on the promise that the systematic risk attached to security is the same irrespective of any number by security in the portfolio.

The total risk of the portfolio is reduced with an increase in the number of stocks as a result of the decrease in the unsystematic risk distribution over the number of stocks in the portfolio.

A risk-averse investor prefers to invest in risk-free securities. A small investor having few securities has greater total risk.

**To reduce the unsystematic risk**, he must build up well-diversified securities in his portfolio.

A diversified and balanced portfolio of all securities will bring an investor systematic risk to the level of average systematic risk in the stock market as a whole.

## Assumptions of Capital Asset Pricing Model (CAPM)

Following are the basic assumption of the capital asset pricing model:

### 1. Investor’s Objective is to Maximize the Utility of Terminal Wealth

Investor aims at maximizing the utility of his wealth, rather than wealth or return.

The difference between them is that individual preferences are taken into account in the utility concept.

While some have a preference for larger risk who will have increasing marginal utility for wealth, for others, with less preference for the risk the international wealth will be less attractive if it is attached with more risk.

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### 2. Investors have Homogeneous Expectations of Risk and Return

Investors have similar expectations of risk and return because without this, the estimates of mean and variance may lead to different forecasts with the result that the **efficient portfolio** of each will be different from that of others.

If investors do not have similar expectations, there will be no homogeneity in their conceptions and no single efficient frontier line will apply to all.

### 3. Investor Make Choices on the Basis of Risk and Return

Investors make investment decisions on a rational basis, depending on their assessment of risk and return.

Risk is measured by two factors, mean and variance.

**In CAPM**, we assume that rational investors diversify away from their unsystematic risk and only systematic risk remains, which varies with the Beta of the security. Key Factors to be Considered in Industry Analysis.

### 4. Investors have Identical Time Horizons

This assumption suggests that investors form portfolios to achieve wealth at a single, common terminal rate.

**That single**, common horizon allows us to construct a single-period model.

This model implies that the investors buy all the assets in their portfolio at one point in time and sell them at some undefined but common in the future.

This assumption is obviously unrealistic.

### 5. Information is Freely and Simultaneously Available to Investors

Investors will have access to all available information at no cost and no loss of time of the information is not the same for all, no common efficient frontier line can be drawn.

### 6. There are a Risk-Free Asset and Investors can Borrow and Lend Unlimited Amount at the Risk-Free rate

This may be the most crucial **assumptions of CAPM**.

The risk-free asset is needed to simplify the complex page wise covariance of Markowitz’s theory.

Risk if increased or decreased by adding a portion of the risk-free assets or by borrowing at the risk-free rate to invest additional funds in the market portfolio.

### 7. No Taxes, Transaction Costs, and Restrictions on Short Rate or Other Market Imperfections

This assumption has several implications for CAPM.

**First**, the assumption about short sales complements the assumption about a risk-free asset.

Role showed that there must be either a risk-free asset or a portfolio of short sold securities for the Capital Market Line (CML) to be straight if there were no risk-free assets the investor could create one by short selling securities.

**Second**, of three assumptions specific to the CAPM, this one removes the real-world problems of transaction costs and taxes.

### 8. Total Assets Quality is Fixed, and All Assets are MArketable and Divisible

This assumption suggests that we can ignore liquidly and new issues of securities.

If such a thing can not be ignored, then the simple CAPM cannot capture all that is, important in pricing securities.

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