Capital Market Theory - CAPM and the Efficient Frontier › Assumptions of CAPM

CAPM builds on the mean-variance framework but requires additional assumptions to derive equilibrium pricing relationships. These assumptions matter because violations help explain why the model's predictions sometimes differ from empirical observations.

The key assumptions underlying CAPM are:

• Investors are mean-variance optimizers: All investors make decisions based solely on expected return and variance of portfolio returns. This follows directly from our work in the previous chapter on Modern Portfolio Theory.

• Single-period investment horizon: All investors plan for the same single holding period. There are no intermediate consumption decisions or multi-period dynamics.

• Homogeneous expectations: All investors share identical beliefs about expected returns, variances, and covariances of all assets. Given the same information, everyone forms the same forecasts.

• Perfect capital markets: No transaction costs, no taxes, and all assets are perfectly divisible. Investors can buy or sell any quantity of any asset without market impact.

• Unlimited borrowing and lending at the risk-free rate: Investors can borrow or lend any amount at a single risk-free interest rate $R_f$.

• No short-selling restrictions: Investors can take unlimited short positions in any asset.

• Price-taking behavior: Individual investors are small relative to the market and cannot influence prices through their trades.

These assumptions are clearly unrealistic, but they allow us to derive clean theoretical results. The model's value lies not in perfectly describing reality but in providing a framework for understanding risk and return relationships. We'll discuss how violations of these assumptions affect the model's empirical performance later in this chapter.