CAPM assumptions CAPM assumptions

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February 13, 2009
February 13, 2009
Public
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The assumptions of the Capital Asset Pricing Model explaining its limitations when using for a hedge fund assessment

Based on the Markowitz’s mean-variance model, the CAPM inherits all the shortcomings of the latter in addition to its own assumptions such as:


1.    Investors are rational and risk averse. They pursue the only interest of maximizing the expected utility of their end of period wealth. Implication: The model includes the single time horizon for all investors.
2.    The markets are perfect, thus taxes, inflation, transaction costs, and short selling restrictions are not taken into account.
3.    Investors can borrow and lend unlimited amounts at the risk-free rate (erf ).
4.    All assets are infinitely divisible and perfectly liquid.
5.    Investors have homogenous expectations about asset returns. In other words, all investors agree about mean and variance as the only system of market assessment, thus everyone perceives identical opportunity. The information is costless, and all investors receive the same information simultaneously.
6.    Asset returns conform to the normal distribution.
7.    The markets are in equilibrium, and no individual can affect the price of a security.
8.    The total number of assets on the market and their quantities are fixed within the defined time frame.
While the CAPM emerges as the most commonly used approach for both institutional and private investors, somebody has to prove that this simple model really holds true in the market.

Article is in the following categories:
Quant KB » Portfolio Composition» CAPM


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