This model generated the idea of beta, that is, the risk of the specific stock. The CAPM model thus is mainly used by firms for estimating the cost of equity.
The CAPM model makes some assumptions for calculating the price of the securities which are risky. These assumptions are as follows :
• The market is efficient and perfect. The information regarding the market is easily available to all the investors. No single investor can influence the stock price change of the market. As the market is efficient there is no transaction cost, no taxes (kapil, 2011, p.168).
• The investors are risk averse in nature. All the investors have same expectation about the return from the market. It is also assumed that the assets are perfectly liquid and they are divisible infinitely. It means the investor can buy or sell any amount of stock. It is also assumed that all assets can be sold or bought in the market by the investors including the human capital.
• At the risk free rate the investors can borrow or lend unlimited amount and they can expect risk free rate of interest from the funds.
• Unlimited short selling is allowed as per the assumption of CAPM model.
• The investors are concerned with a single period price of asset and the mean and variance of the concerned asset (Elton et al, 2009, p.283).