CAPM is the word which is used in financial markets, the full form of CAPM is Capital Asset Pricing Model also known as 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 calculated as – Risk free rate + Beta of the Security(Market Return – Risk free rate). So for example if we know the risk free rate of return is 5 percent and beta of security is 2 and excepted market return is 10 percent then we can compute the excepted return of stock will be 15 percent which can be calculated as 5 + 2(10-5). Capital asset pricing model is based on certain assumptions, lets look at some of the assumptions of CAPM
Assumptions of Capital Asset Pricing Model
Risk Averse Investors
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.
Time Horizon of the Investors
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.
Low Transaction Costs
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.
Availability of Information
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.