Investment Theories

Question 1

What are the main assumptions of CAPM? (8)

Answer 1

• Borrowing and lending all takes place at the risk-free rate.
• Investors have diversified away all non-systematic risk.
• No tax or transaction costs.
• Maximising return for a given level of risk is sole incentive for all investors.
• Investors retain identical expectations of returns and standard deviations of all assets.
• Market has many buyers and sellers
• All information available to all parties
• No one investor can influence the market price

Question 2

What are the benefits of CAPM?

Answer 2

• Easy to calculate
• Robust
• Allows for systematic risk
• Ignores non-systematic risk
• Easy to compare portfolios
• Gives an expected return

Question 3

What are the drawbacks of CAPM?

Answer 3

• Risk free rate may be incorrect
• Unrealistic assumptions
• Assumes beta suitable measure of market risk
• Beta is unstable
• Doesn’t account for charges
• Assumes single holding period
• Single factor/simplistic