Why we don't use CAPM to price derivatives?
Hi everyone,
It's a thought exercise by my professor. My initial intuition tells me that CAPM cannot be applied to derivatives, but I’m having trouble articulating why this is the case... This might be a silly question but I really don't know exactly why
Google what assumptions CAPM relies on and then check out some articles on derivatives and how they’re used for hedging, why firms hedge, how hedges are structured between parties.
Typical CAPM assumptions are: (1) frictionless market (2) investors hold homogenous expectation (3) investors hold risky portfolios and want to max E(r) while min volatility. But as far as I know CAPM still allows for heterogenous risk preference(?) Like, risk averse investors may hold more of risk free asset and less of the market portfolioI know people use derivatives to manage risks, and I know always people don't have homogenous expectations. However I'm still a bit confused about in which way the nature of derivatives violates the CAPM consumptions? Anyway thank you very much! It's so kind of you to answer such a naive question :D
Comment deleted
well, let's reverse this, and let's ask you how would you apply CAPM
maybe this will help you reflect and find the flaw
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