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    CAPM: how does it work; what are strengths and weaknesses?

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    How does the Capital Asset Pricing Model (CAPM) works. What are the strengths and weaknesses of the CAPM? Please be specific.

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    CAPM is a single factor, simplest and most commonly used asset-pricing model in finance. It is "single factor" in the sense that there is only one explanatory variable (risk premium of the market as a whole i.e. rm - rf). The salient points of CAPM model are:

    i. Investors are only compensated for bearing market risk
    ii. The market portfolio is the optimal risky portfolio (tangency portfolio)
    iii. Investors will hold some combination of the risk free asset and market portfolio
    iv. In equilibrium all securities plot on SML
    v. Single source of risk - market risk

    Researchers for following reasons criticize CAPM:
    · Assumptions are quite strict
    · There must be more than one dimension to asset pricing
    · CAPM is not 'theory' since it cannot be ...

    Solution Summary

    CAPM: how does it work; what are strengths and weaknesses? (500 words with references)