One goal of CAPM Tutor is to help you understand exactly how investors value the risky cash flows that result from holding stocks, and how they make their investment decision. You will be able to actually experience this process by experimenting with the investment decision in the interactive environment of CAPM Tutor.
This requires us to be able to quantify investor attitudes toward risk and return, the nature and timing of cash flows, the nature of the market in which trades occur, and so on. All these attitudes are described in a set of assumptions, which not only tell you the conditions under which the theory holds but also make the investment problem manageable. These assumptions form the foundation of modern portfolio theory; many extensions of the theory have been developed that relax or modify the assumptions.
1. Each investor is assumed to be a price taker. That is, each investor is assumed to be small compared to the market as a whole, in that the actions of one investor do not exert a significant influence on market prices.
2. All investors have a fixed single period investment horizon. That is, initially we develop the theory of investment using a one-period model.
3. The market is perfect in the sense that there are no transaction costs or taxes, securities are completely divisible, and investors have equal access to information.
This assumption is a major simplification. It allows the investment problem to be studied under idealized conditions. We do not have to deal with the institutional complexities associated with buying and selling securities. We are not distracted by the complexities of the tax code, which changes every year. We do not have to worry about "integer solutions" and the fact some investors have access to different pieces of information than others.
4. Any dividend payments from a stock occur only at the end of the period. Investors are indifferent between receiving $1 of dividend and $1 of capital gain from the sale of a security.
5. Investors have individual preferences as to risk and return, but strictly prefer more expected return to less and less risk to more.
6. All investors have the same information about future cash flows.
7. The supply of shares of each firm, and the total number of firms, is fixed.
Using these assumptions, we can start developing the theory of optimal portfolio choice. The first step in this development is presented in the topic Evaluation of Risky Cash Flows.
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