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CAPM assumes that “all assets are tradable”. How would the violation of this assumption affect the model? Give an example of assets that are not tradeable in the real world.
CAPM (Capital Asset Pricing Model) is a financial model that aims to explain the relationship between expected returns and risks for an individual asset or portfolio. The assumption that “all assets are tradable” is crucial to the CAPM as it allows investors to build well-diversified portfolios with different assets to minimize risks.
If this assumption is violated, the CAPM may not be able to accurately estimate expected returns and risks for assets. This is because the model assumes that investors can easily buy and sell any asset they want, and the market is perfectly efficient, which means that all assets are priced correctly based on their risks and returns.
However, if an asset is not tradable, it means that it cannot be bought or sold in the market, or its liquidity is low. As a result, the asset may have a unique risk and return profile that is not reflected in the CAPM. This could lead to inaccurate estimates of the asset’s expected returns and risks, and ultimately affect the performance of portfolios that include this asset.
An example of assets that are not tradeable in the real world are non-publicly traded companies or private equity investments. Private equity investments typically involve buying shares in a company that is not listed on a stock exchange, and the shares cannot be easily bought or sold on the open market. Therefore, their valuation is often more difficult, and their risks and returns may not be accurately reflected in the CAPM. Other examples include certain types of real estate, art collections, and rare collectibles.
What is the implication of CAPM for passive investment strategy? Discuss.
One of the key implications of CAPM for passive investment strategy is that it provides a basis for constructing a well-diversified portfolio of assets that matches the investor’s risk tolerance. According to the CAPM, an asset’s expected return is proportional to its systematic risk, which is measured by beta. Therefore, by selecting assets with different betas, investors can build a portfolio with the desired level of risk exposure.
For passive investors, the CAPM suggests that investing in a portfolio that tracks a market index is a viable strategy for achieving market-like returns while minimizing idiosyncratic risk.
