Final answer:
CAPM is a model used to determine the expected return of an investment based on its risk, aiding in pricing securities and estimating the cost of equity. Its main assumptions include risk-aversion, divisibility of assets, absence of costs, all investors having the same information, and the ability to borrow at the risk-free rate. The practical application of CAPM is limited by real-world factors such as transaction costs and diverse investor behavior.
Step-by-step explanation:
What is CAPM?
The Capital Asset Pricing Model (CAPM) is a foundational concept in modern finance that describes the relationship between the expected return on an investment and its risk. CAPM serves to assess the attractiveness of an investment by determining the expected return given the risk-free rate, the investment's systematic risk, and the expected market return. Specifically, it is useful for estimating the cost of equity and is frequently used in the fields of finance and investments to price risky securities and generate estimates of expected returns considering the inherent risks.
Main Assumptions of CAPM
Investors are risk-averse and aim to maximize economic utilities.
Assets are infinitely divisible, meaning that it's possible to buy any fractional amount of an asset.
There are no transaction costs or taxes, and all information regarding financial markets is available to all investors at the same time.
Investors can borrow and lend unlimited amounts at the risk-free rate of interest.
Investors hold homogenous expectations, which means they have the same outlook and information about the returns on investments.
These assumptions imply that markets are perfectly efficient, but in reality, this is not the case, thus limiting the practical application of CAPM. Critics point out that real markets have transaction costs, investors have diverse opinions, and the model fails to account for an active investor's ability to earn extra returns through strategies not reflected in the market portfolio.