Introduction

The Capital Asset Pricing Model (CAPM) is a foundational framework in finance that helps investors assess the expected return on an asset in relation to its risk. However, the model is built on a set of assumptions that serve as the foundation for its calculations and interpretations. In this chapter, we will delve into the key assumptions underlying CAPM and understand their implications for asset pricing and portfolio management.

Assumptions Underlying the CAPM

1) Perfect Markets: CAPM assumes the presence of perfect markets, characterized by:

• No restrictions on borrowing or lending at the risk-free rate.
• No transaction costs for buying or selling securities.
• All investors have access to the same information and share the same expectations.

Example: In a perfect market, all investors can trade securities without incurring any costs, leading to a level playing field for all participants.

2) Single-Period Investment Horizon: CAPM assumes that investors have a single-period investment horizon. This simplification facilitates calculations and analysis by focusing on a single time period.

Example: An investor evaluating a stock’s potential returns for the upcoming year aligns with the single-period assumption.

3) Homogeneous Expectations: CAPM assumes that investors share homogeneous expectations about asset returns and risk. In other words, investors base their decisions on the same information and hold similar views about future market conditions.

Example: Under homogeneous expectations, all investors anticipate the same future returns for a given asset based on shared information.

4) No Taxes: The model assumes that taxes do not affect investment decisions. This simplification allows the focus to remain on the relationship between risk and return without the added complexity of taxation.

Example: Investors can concentrate solely on assessing an asset’s risk and return potential, without considering tax implications.

5) No Riskless Arbitrage Opportunities: CAPM assumes that riskless arbitrage opportunities are not available in the market. This implies that investors cannot make risk-free profits by exploiting price discrepancies.

Example: If riskless arbitrage were feasible, investors could buy and sell assets to eliminate any mispricing and earn guaranteed returns.

6) Homogeneous Asset Classes: The model assumes that all assets can be classified into homogeneous risk classes. In other words, assets are similar in terms of risk characteristics.

Example: If two stocks exhibit similar levels of risk based on their beta values, they can be classified into the same risk class.