Capital Asset Pricing Model (CAPM)
An analysis of the CAPM theory using the practice of positive economics.
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The paper examines this theory which helps analysts to identify appropriate measures of risk for an efficient portfolio and defines the relationship between risk and return for efficient portfolio. The paper shows how the CAPM theory also estimates the measure of risk for an individual security or an inefficient portfolio and defines the relationship between risk and return for an individual security or inefficient portfolio. A worked example is supplied towards the end of the paper.
“The theory of CAPM (Capital Asset Pricing model) is based on several assumptions. The primary assumption while conducting the risk analysis of an investment portfolio is that the individuals are usually reluctant to take risk. It also assumes that the individuals search for ways to maximize the expected usefulness of their portfolios with a single planning period. Moreover, individuals have analogous expectations relating to the return on their investment portfolios. In other words, their subjective estimates regarding the means, variance and covariance of the investment returns are almost similar. Individuals can also freely borrow capital for investment and can lend capital as well. This borrowing can be made on a risk free rate of return. In addition to this, this theory also assumes that the market is operating under ideal conditions, no taxes are to be paid, transactions costs are almost negligible, securities are completely discernible and firms operate in an environment of perfect competition. Finally, quantity of risky securities can be easily determined.”