LOS c: State the assumptions of the domestic capital asset pricing model (CAPM).

Q1. Users of the capital asset pricing model (CAPM) must assume that:

A)   inflation remains moderate.

B)   all investors are risk-averse.

C)   exchange rates are not excessive.

Q2. Horace Malthusson likes to use the CAPM in his stock valuation. When using the CAPM to value stocks, Malthusson assumes that he can borrow money at the risk-free rate, tax rates are stable, and every investor has the same expected rate of return. The assumptions required by the CAPM differ from Malthusson’s assumptions with regards to:

A)   expected returns.

B)   tax rates.

C)   borrowing capability.

Q3. The capital asset pricing model (CAPM) is least effective when used to value:

A)   thinly traded stocks.

B)   extremely volatile stocks.

C)   bonds.

LOS c: State the assumptions of the domestic capital asset pricing model (CAPM). fficeffice" />

Q1. Users of the capital asset pricing model (CAPM) must assume that:

A)   inflation remains moderate.

B)   all investors are risk-averse.

C)   exchange rates are not excessive.

Correct answer is B)

One of the assumptions of the CAPM is that all investors are risk-averse, preferring more return and less risk, all else equal. The other assumptions are not required.

Q2. Horace Malthusson likes to use the CAPM in his stock valuation. When using the CAPM to value stocks, Malthusson assumes that he can borrow money at the risk-free rate, tax rates are stable, and every investor has the same expected rate of return. The assumptions required by the CAPM differ from Malthusson’s assumptions with regards to:

A)   expected returns.

B)   tax rates.

C)   borrowing capability.

Correct answer is B)

The capital asset pricing model requires that investors assume there are no taxes. Malthusson’s other assumptions match those of the CAPM.

Q3. The capital asset pricing model (CAPM) is least effective when used to value:

A)   thinly traded stocks.

B)   extremely volatile stocks.

C)   bonds.

Correct answer is C)

The CAPM uses beta to reflect volatility, so it can handle volatile stocks. Thinly traded stocks are a problem, but as long as trading is sufficient to provide a beta, the CAPM can be used. It is also possible to estimate beta for thinly traded stocks. However, the CAPM does not work at all for bonds. It uses an equity risk premium, and as such is designed for use only with equities.