Capital asset pricing model (CAPM) is one which establishes the relationship between the required rate of return of a security and its systematic risk also known as risk which is not diversification. It can be represented mathematically as –
For example if we know the risk free rate of return is 5 percent and beta of security is 2 and excepted market return is10 percent then we can compute the excepted return of stock will be 15 percent which can be calculated as 5 + 2(10-5)
Here are some of the assumptions of CAPM
1. Investors are risk averse as well as rational and use standard deviation and expected rate of return for measuring the risk and return for their portfolios. Hence higher the risk of a portfolio higher will be the return excepted by the investors.
2. Investors make their investment decision based on a single period horizon rather than multiple period horizons. Also taxes do not affect the buying choice of the investors.
3. Transactions costs in the financial markets are assumed to be very low and also assets can be bought and sold in any division desired by the investor. Hence investors can lend and borrow unlimited amount of money at the risk free rate of interest prevailing in the market.
4. It assumes that all information is available to all investors at the same time.
Hence from the above one can see that CAPM is based on assumptions which cannot be possible in real world but still it has wide applications in security market and hence it is very important concept as far as stock markets are concerned.