Topic 4 - Asset Pricing Theory

Question 1

Capital asset pricing model (CAPM)

Answer 1

• Equilibrium model that underlies all modern financial theory
• Derived using principles of diversification, but with other simplifying assumptions

Question 2

Simplifying assumptions of CAPM

Answer 2

• Individual investors are price takers
• Single-period investment horizon
• Investments are limited to traded financial assets
• No taxes and no transaction costs
• Information is costless and available to all investors
• Investors are rational mean-variance optimisers
• Homogeneous expectations