6.1 CAPM: Idea of CAPM

Question 1

Markowitz portfolios: in the previous chapter we looked at individual investors deciding according to his preferences about her optimal portfolio – assuming normally distributed returns and efficient portfolios determined only by risk (variance) and return.

What happens if we have many investors and bring them together in a capital market?

Answer 1

–> CAPM introduces the idea of equilibrium and can tell us which asset prices will result if market participants invest in efficient Markowitz portfolios.

Question 2

CAPM Assumptions: Normative. Describe them. (4)

Answer 2

Three similar to Markowitz model: perfect frictionless cap market, risk averse non satiated investors, asset returns follow a multivariate normal distribution

Added: homogeneous expectations.

Question 3

CAPM Assumptions: Additional ones which can be relaxed but only makes the derivation easier. Describe them. (3)

Answer 3

One period investment horizon;
Risk free asset exists;
Risk free rate is the same for all investors