Topic: Explain CAPM with assumptions.

Introduction:-
Investors who have a portfolio of securities may like to add some more securities to the existing portfolio in
order to diversify or reduce the risks. So, it is appropriate to study the extent of risks of a security in terms
of its contribution to the riskiness of a portfolio.

Capital Asset Pricing Model (CAPM) is a measure of the relationship between the expected return and the
risk of investing in security. This model is used to analyze securities and pricing them given the expected
rate of return and cost of capital involved.

The Formula for calculating it is:

Ra = Rrf + βa*(Rm - Rrf)

Where,

Ra = Expected return on a security

Rrf = Risk-free rate

Ba = Beta of the security

Rm = Expected return of the market

The CAPM formula is used for calculating the expected returns of an asset. It is based on the idea of
systematic risk (otherwise known as non-diversifiable risk) that investors need to be compensated for in
the form of a risk premium. A risk premium is a rate of return greater than the risk-free rate. When
investing, investors desire a higher risk premium when taking on more risky investments.

Advantages:-
 1. CAPM takes into account only the systematic or market risk or not the security’s only inherent or
systemic risk. This factor eliminates the vagueness associated with an individual security’s risk and
only the general market risk which has a degree of certainty becomes the primary factor. The
model assumes that the investor holds a diversified portfolio and hence the unsystematic risk is
eliminated between the stock holdings.

2. It is widely used in the finance industry for calculating the cost of equity and ultimately for
calculating the weighted average cost of capital which is used extensively to check the cost of
financing from various sources. It is seen as a much better model to calculate the cost of equity
than the other present models like the Dividend growth model (DGM).

3. It is a universal and easy to use model. Given the extensive presence of this model, this can easily
be utilized for comparisons between stocks of various countries.

Disadvantages:-

1. The capital asset pricing model is hinged on various assumptions. One of the assumptions is that a
riskier asset will yield a higher return, next the historical data is used to calculate Beta. The model
also assumes that past performance is a good measure of the future results of a stock’s functioning.
However, that is far from the truth.

2. The model also assumes that the risk-free return will remain constant over the course of the stock
investment. If the return on the government treasury securities rises or falls it will change the risk-
free return and potentially the calculation of the model. This is not taken into account while
calculating the CAPM

3. The model assumes that the investors have access to the same information and have the same
decision-making process with respect to the risks and returns associated with the securities. It
assumes that for a given return the investors will prefer low-risk securities to high-risk securities
and for a given risk the investors will prefer higher returns to lower returns. Although this is a
general guideline, some of the more extravagant investors might not be in agreement with this
theory.

Assumptions:-

1. Risk-averse investors: The investors are basically risk averse and diversification is necessary to
reduce their risks.

2. Maximising the utility of terminal wealth: An investor aims at maximizing the utility of his wealth
rather than the wealth or return. The term ‘Utility’ describes the differences in individual
preferences. Each increment of wealth is enjoyed less than the last as each increment is less
important in satisfying the basic needs of the individual. Thus, the diminishing marginal utility is
most applicable to wealth.There are also other forms of utility functions.
 3. Choice on the basis of risk and return: Investors make investment decisions on the basis of risk and
return. Risk and return are measured by the variance and the mean of the portfolio returns. CAPM
assumes that the rational investors put away their diversifiable risk, namely, unsystematic risk. But
only the systematic risk remains which varies with the Beta of the security.

4. Similar expectations of risk and return: All investors have similar expectations of risk and return. In
other words, all investors’ estimates of risk and return are the same.

5. Identical time horizon: The CAPM is based on the assumption that all investors have identical time
horizon. The core of this assumption is that investors buy all the assets in their portfolios at one
point of time and sell them at some undefined but common point in future. This assumption further
implies that investors form portfolios to achieve wealth at a single common terminal rate.

6. Free access to all available information: One of the important assumptions of the CAPM is that
investors have free access to all the available information at no cost. Supposing some investors
alone are able to have access to special information which is not readily available to all, then the
markets would not be regarded efficient. In other words, if the available information has not
reached all, it will be difficult to draw a common efficient frontier line.

7. There is risk-free asset and there is no restriction on borrowing and lending at the risk free rate:
This is a very important assumption of the CAPM. The risk free asset is essential to simplify the
complex pairwise covariance of Markowitz’s theory. The risk free asset makes the curved efficient
frontier of MPT to the linear efficient frontier of the CAPM simple.

8. There are no taxes and transaction costs: According to Roll, there must be either a risk free asset or
a portfolio of short sold securities. Then only the capital Market Line (CML) will be straight. When
there are no risk free assets, the investor could not create a proxy risk free asset. As a result, the
capital market line would not be linear and the direct linear relationship between risk and return
would not exist.

9. Total availability of assets is fixed and assets are marketable and divisible: This assumption holds
the view that the total asset quantity is fixed and all assets are marketable. However, models have
been developed to include unmarketable assets which are more complex than the basic CAPM.

Conclusion:-
CAPM is widely regarded as one of the foremost models for calculating the risk and returns associated with
investing in stocks. Although, it utilizes a few assumptions the rationale behind the model and the ease of
use makes it one of the accepted and logical way to help investors in their decision making.