FM – Nov 2016 – L3 – Q5a – Portfolio Management

Explanation of the basic assumptions of the Capital Asset Pricing Model (CAPM).

Question

(a) Capital Asset Pricing Model (CAPM) is an equilibrium model of the trade-off between expected portfolio return and unavoidable risk.

What are the basic assumptions on which this model is based?

Answer

(a) Assumptions of Capital Asset Pricing Model (CAPM):

Efficient Portfolio Selection:
- Investors only need to know the expected returns, the variances, and the covariances of returns to determine which portfolios are optimal for them.
Homogeneous Expectations:
- Investors have identical views about risky assets’ mean returns, variances of returns, and correlations.
Marketability of Assets:
- Investors can buy and sell assets in any quantity without affecting their price, and all assets are marketable (can be traded).
Risk-Free Borrowing and Lending:
- Investors can borrow and lend at the risk-free rate without limit, and they can sell short any asset in any quantity.
No Taxes:
- Investors do not pay taxes on returns.
No Transaction Costs:
- Investors incur no transaction costs on trades.
Single Time Period:
- All investment decisions are based on a single time period.