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The Capital Asset Pricing Model (CAPM)

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The Capital Asset Pricing Model (CAPM) is a cornerstone of financial theory, linking investment risk to expected returns. It assumes rational investors, efficient markets, and no transaction costs, among others. These assumptions, while idealized, are crucial for understanding the dynamics of asset pricing and the systematic approach to investment evaluation. CAPM's beta coefficient and the risk-free rate are key to this model, serving as benchmarks for assessing investment risks and returns.

Exploring the Fundamentals of the Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is an essential theoretical construct in finance that delineates the relationship between the expected return of an investment and its inherent risk. Central to CAPM are its foundational assumptions, which streamline the complexities of financial markets for analytical clarity. These assumptions posit that investors are rational and averse to risk, markets are perfectly competitive and operate efficiently, and that there are neither transaction costs nor taxes impacting trades. Furthermore, CAPM presupposes the infinite divisibility of securities and that all investors have uniform access to information and identical expectations regarding future returns. It also assumes that investors can borrow and lend unlimited amounts at a risk-free interest rate. While these assumptions may not precisely reflect real-world conditions, they are indispensable for applying the model to financial decision-making and the pricing of assets.
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The Significance of Risk-Free Rate and Market Return in CAPM

The CAPM framework hinges on the risk-free rate, which is the hypothetical return of an investment devoid of any risk, typically represented by government securities like treasury bills. The expected return on an investment, according to CAPM, is calculated using the formula \( r_i = r_f + \beta_i (r_m - r_f) \), where \( r_i \) denotes the expected return, \( r_f \) the risk-free rate, \( \beta_i \) the investment's beta coefficient, and \( r_m \) the expected market return. The expected market return is the mean return of the market portfolio, comprising all investable assets, and is a critical factor in shaping the security market line (SML), which in turn influences the expected return of individual securities. These components are integral to comprehending how CAPM's assumptions underpin the evaluation of investment risks and returns.

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00

CAPM: Expected Return vs. Risk

CAPM outlines a linear relationship where higher risk investments should yield higher expected returns.

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CAPM: Market Conditions

Assumes markets are perfectly competitive, efficient, with no taxes or transaction costs.

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CAPM: Investor Behavior and Access

Investors are rational, risk-averse, have equal information, and uniform expectations on returns.

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