Question

Which of the following statements about the Capital Asset Pricing Model (CAPM), which is the “father” of the Security Market Line (SML), is most correct?

A	The CAPM is based on a restrictive set of assumptions.

B	It has not been empirically verified.

C	In general, its inputs are difficult to estimate.

D	In spite of its deficiencies, it provides investors with a rational way of thinking about required rates of return.

E	All of the above responses are correct.

Answer 1

Option E is correct.

CAPM provides investors a very rational and easy way of thinking about required rate of return. Required return as per CAPM is computed as -

Required return = Risk free rate + Beta x (Expected return of market - Risk free rate)

CAPM has many restrictive set of assumptions such as no taxes, restrictions on short rates and other market imperfections, securities can be exchange without payment of brokerage commission and without any transaction cost. In addition, CAPM has also not been empirically verified.