assumptions of CAPM

The Capital Asset Pricing Model (CAPM) is based on a set of assumptions that form the foundation of the model. These assumptions help simplify the analysis and provide a framework for understanding the relationship between risk and return. The key assumptions of the CAPM are as follows:

1. Efficient Markets: The CAPM assumes that markets are efficient, meaning that all relevant information is instantly and fully reflected in asset prices. This implies that investors cannot consistently achieve abnormal returns by exploiting market inefficiencies.
2. Rational Investors: The CAPM assumes that investors are rational and make decisions based on maximizing their utility. They have homogeneous expectations about future returns and risk and consider only the mean and variance of returns when evaluating investment opportunities.
3. Risk Aversion: The CAPM assumes that investors are risk-averse, meaning they prefer lower levels of risk and require higher expected returns to compensate for taking on higher levels of risk.
4. Single Period Holding: The CAPM assumes a single-period investment horizon, meaning that investors only consider the expected returns and risks over a specific period and do not take into account longer-term considerations.
5. Homogeneous Assets: The CAPM assumes that all investors have access to the same set of risky assets, and these assets can be freely bought and sold without any restrictions or transaction costs.
6. No Taxes or Transaction Costs: The CAPM assumes that there are no taxes or transaction costs associated with buying or selling assets. This assumption allows for frictionless trading and simplifies the analysis.
7. Borrowing and Lending at Risk-Free Rate: The CAPM assumes that investors can borrow and lend money at a risk-free rate, which represents an asset with no risk of default. This assumption allows for risk-free investment opportunities and helps establish a benchmark for evaluating the risk and return of other assets.