Asset Pricing Models

Question 1

Assumption of CAPM

Answer 1

• All period have the same one-period horizon
• All investors can borrow or lend unlimited amounts at the same risk-free rate
• The markets for risky assets are perfect. Information is freely and instantaneously available to all investors and no investors believe that they can affect the price of a security by their own actions
• Investors have the same estimates of the expected returns, standard deviations and covariances of securities over the one-period horizon

Question 2

Results of the CAPM

Answer 2

• All investors have the same efficient frontier of risky assets
• The efficient frontier collapses to a straight line in E-sigma space in the presence of the risk-free asset
• All investors hold a combination of the risk-free asset
• All investors hold a combination of the risk-free asset and the same portfolio of risk-free assets M
• M is the market-portfolio - it consists of all assets held in proportion to their market capitalisation

Question 3

Basic Requirements for a Perfect Market

Answer 3

• There are many buyers and sellers so that no one individual can influence the market price
• All investors are perfectly informed
• Investors all behave rationally
• There is a large amount of each type of asset
• Assets are perfectly divisible
• There are no taxes
• there are no transaction costs

Question 4

Separation Theorem

Answer 4

• The fact that since the optimal combination of risky assets for an investor can be determined without any knowledge of their preference towards risk and return (of their liabilities) is known as the separation theorem
• This suggests the investor’s choice of a portfolio of risky assets is independent of their utility function