Final answer:
The Capital Asset Pricing Model (CAPM) involves assumptions such as homogeneous expectations, a risk-free rate, and frictionless markets, but faces limitations due to market imperfections, difficulties in defining the market portfolio, and varying investor information access.
Step-by-step explanation:
The Capital Asset Pricing Model (CAPM) is a financial model that aims to determine the expected return on an asset while considering the asset's risk compared to the market.
Major assumptions of the CAPM include investors having homogeneous expectations and access to all information, the existence of a risk-free rate, and the ability to borrow and lend at this rate. Additionally, CAPM assumes that all investors hold a combination of this risk-free asset and the market portfolio, which is on the efficient frontier.
However, the model comes with significant limitations. It assumes that markets are frictionless, meaning there are neither taxes nor transaction costs. Furthermore, CAPM presupposes that all assets are infinitely divisible, that investors have a single-period investment horizon, and that they are rational and risk-averse.
These conditions are not always met in real-world scenarios, leading to inaccuracies when CAPM is applied. Moreover, the model relies heavily on the market portfolio being accurately defined, which is difficult in practice.
Imperfections in market information and the difference in access to information among various investors also contribute to the limitations of CAPM.