Lesson 6: Capital Asset Pricing Model

Question 1

What are the three assumptions of the Capital Asset Pricing Model (CAPM)

Answer 1

1. Efficient transactions
2. Rationality
3. Homogenous expectations

Question 2

What is the efficient transaction assumption of CAPM?

Answer 2

Investors can buy and sell all securities at competitive market prices with no transaction costs, and can borrow or lend at the risk-free rate.

Question 3

Define the rationality assumption of CAPM

Answer 3

Investors hold only efficient portfolios, portfolios that maximize the Sharpe ratio.

Question 4

Define the homogenous expectations assumption of CAPM

Answer 4

Investors have homogenous expectations regarding expected returns, volatilities, and correlations of securities.

Question 5

What is the Capital Market Line?

Answer 5

The line on the volatility/return graph going through the point with volatility 0 and the risk-free return and through the tangent portfolio point for the market portfolio. Individual investments carry market and idiosyncratic risk, so the sharp ratios for individual investments plot below the capital market line.