Question

CAPM is a theoretical model that relies in many assumptions. One of them relates to the efficiency of the market portfolio. What stock indices are commonly used as market proxies? Are they good? Can we say they are efficient?

Answer 1

There is an inherent amount of risk associated when we trade and even diversify portfolio. Investor would seek rate of return to compensate for the risk. The capital asset pricing model helps to calculate investment risk and what return on investment an investor should expect or evaluate the risk return trade-off for diversified portfolios and individual assets. It estimates the cost of capital as the sum of a risk-free rate and a premium for the risk of the particular security.

The best proxy for the risk-free rate may be short-term government interest rate and investors may prefer to increase their returns in an efficient manner by leveraging the market portfolio with the given market proxy

The underlying key assumptions of CAPM may be

• Investors are rational and are expected to make decisions based solely on risk-return assessments
• Investors have homogenous expectations.
• All assets are publicly traded.
• Investors can borrow or lend at a common risk-free rate.
• There is perfect competition and no single investor can influence prices, with no transactions costs, involved