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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.
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Investors are assumed to be rational and averse to risk, simplifying the decision-making process
Markets are assumed to be perfectly competitive and efficient, allowing for analytical clarity
The model assumes that there are no transaction costs or taxes impacting trades, simplifying investment analysis
The risk-free rate is the hypothetical return of an investment devoid of any risk and is a critical factor in the model
The beta coefficient quantifies an asset's systematic risk in relation to the broader market
The expected market return is the mean return of the market portfolio and influences the security market line
The assumptions of CAPM may not accurately reflect real-world conditions, leading to discrepancies between theoretical forecasts and actual market behavior
The assumption of zero transaction costs and rational behavior may not hold in reality, impacting the accuracy of the model
The assumptions of infinite divisibility and uniform access to information may not be feasible in real financial markets
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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.
