Ans. According to CAPM, there is an implied
equilibrium relationship between risk and return for each security. Under the
conditions of market equilibrium, a security is expected to provide a return
commensurate with its unavoidable risk. The greater the unavoidable risk of a
security, the greater the return that investors will expect from the security.
The relationship between the expected return and unavoidable risk and the
valuation of securities is the essence of CAPM. Stated in other words, “the
risk averse investors will not hold risky assets, unless they are adequately
compensated for the risks, they bear”. Assumptions of the Model: The following
are the important assumptions of the model.
1.
Investors make their decisions only on the basis of the expected return, risk
associated with the security.
2.
An individual investor cannot influence the price of a stock in the market.
3.
Investors can lend or borrow funds at the riskless rate of interest.
4.
Assets are infinitely divisible.
5.
There are no transaction costs involved on buying and selling of stocks.
6. There is no personal income Tax.
It
implies that the investor is indifferent between capital gain and dividend.
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