Question

Compare and contrast CAPM with multifactor models of stock returns with respect to assumptions, approach, estimation, benefits and limitations ect.

Answer 1

Assumptions of CAPM

1) Investors are risk averse.

2) Utility maximizing investors : Investors choose the portfolio , based on their individual preferences , with the risk and return combination that maximizes their utility.

3)Frictionless markets : No taxes , transaction costs etc.

4) One period horizon : All investors have same time horizon.

5) Homogenous expectation : All investors have same expectations for assets expected returns, their standard deviation and correlation between them.

6) Divisible assets : All investments are infinitely divisible.

7) Competitive markets : Investors take the market price as given and no investor can influence prices with their trades.