Question

Explain what the capital asset pricing model (CAPM) is mainly used for, and its theoretical foundation.

Answer 1

The capital asset pricing model (CAPM) is mainly used for finding the required rate of return on an asset. The assets could be stocks.

The CAPM equation is given by:

Where,

re = required rate of return on equity

rf = risk-free rate

beta of the stock

rm = return on the market

Theoretically, the CAPM makes the following assumptions:

• The markets are highly efficient and there are no taxes, no transaction costs, no inflation etc.
• All the investors hold perfectly diversified stocks and there is no unsystematic risk
• All investors are risk averse and rational
• Investors can borrow and lend money at the risk-free rate and the amount that can be borrowed or lent is unlimited
• Investors are exposed only to the market risk
• All the stocks are highly liquid