CAPM

The Capital Asset Pricing Model (CAPM) is "A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities" (Investopedia). And the basic idea of this is that reducing or removing risk has no effect on the value of the publicly traded firm.

However there are many assumptions associated with CAPM. And they are as follows:

• Publicly traded firm
• Many shareholders with diversified portfolios
• Management is risk neutral
• No agency problems
• Uninsured risk is uncorrelated with risk of other securities in portfolio
• No taxes

Although the assumptions listed above are virtually impossible to meet, CAPM still remains one of the most widely used investment models to determine risk and return. For example, as discussed in class, most shareholders are not very well diversified at all which really affects this model. For example, since they are not well diversified when there is a loss it will not be spread out well between them. So, whereas they technically should each only bear a small fraction of the loss, they may be greatly affected. Also, another huge assumption that affects this model is that there are no transactions costs or taxes. In fact, there will always be these costs and they will have a very adverse impact on the expected rate of return.

The website Suite 101 has a great article which depicts what CAPM is, as well as its assumptions and limitations (as these links show).