Answer to Question #160980 in Macroeconomics for hellen

Question

Capital Asset Pricing Model (CAPM) is the theory that underpins asset pricing. Discuss the assumptions and implications of CAPM and the applications of CAPM. 

Answer 1

Assumptions

       i.           Risk-averse investors-diversification is vital to reduce the risks of averse investors.

     ii.           Terminal wealth utility maximization- An investor is trying not to make wealth or return but to optimize his wealth's utility. The word "usefulness" explains the differences in personal choices.

   iii.           Choices based on the risks and returns-The volatility and average portfolio returns are calculated in terms of risk and return. CAPM takes the investors' proper position and set aside their various and unsystematic risks.

   iv.           Similar risks and returns expectations-Every investor has identical risk and return expectations. When investors have different perceptions with different forecasts from mean and variance estimates.

     v.           Identical time horizons-The presumption of a typical period is based on the CAPM.

   vi.           Freedom of access to all information available- The CAPM assumes that information available is open for investors to use at no expense if such investors can access unique details independently.

 

Implications

      i.           The CAPM has ramifications for asset pricing. It specifies the return rates necessary for finding the current value of an asset with a specific systemic risk level.

     ii.           Using CAPM, each investor can evaluate the securities and classify their portfolio composition. Investors are entirely dedicated to calculating potential returns, variances, and covariances. Various investors will select from the same efficient portfolio, but they have unique risks and return preferences.

   iii.           No protection can have a tangential impact on the balance, either danger spatial axis. Everything will be balanced, eventually.

   iv.           Protection prices and rates are set for any individual investor, although the amounts held can be adjusted. Equilibrium calls for improvement of each protection cost until the intended quantity and the quantity available are compatible.

Applications of CAPM

       i.           Evaluation of performance-There is output metrics that are CAPM extensions that can be determined. Active managers should be more successful than passive managers. Both tests presuppose that the portfolio of benchmarks is the right portfolio.

     ii.           Selection of security-CAPM assumes that investors have uniform expectations and are fair and risk-free, and therefore all assets have almost the same value. If investors are heterogeneous, a discount or price for securities different from the CAPM price may produce their various beliefs.

   iii.           The construction of portfolios- A vast proportion of securities form the total market portfolio and may not be reasonable for an investor to own them all. There is no diversification of structural risks implicit in the real market risk.