The CAPM is an important area of financial management. In fact, it has even been suggested that finance only became ‘a fully-fledged, scientific discipline’ when William Sharpe published his derivation of the CAPM in 1986 (Megginson WL, Corporate Finance Theory, Addison-Wesley, p10, 1996).

CAPM ASSUMPTIONS

The CAPM is often criticised as being unrealistic because of the assumptions on which it is based, so it is important to be aware of these assumptions and the reasons why they are criticised. The assumptions are as follows (Watson D and Head A, 2007, Corporate Finance: Principles and Practice, 4th edition, FT Prentice Hall, pp222–3):

Investors hold diversified portfolios

This assumption means that investors will only require a return for the systematic risk of their portfolios, since unsystematic risk has been removed and can be ignored.

Single-period transaction horizon

A standardised holding period is assumed by the CAPM in order to make comparable the returns on different securities. A return over six months, for example, cannot be compared to a return over 12 months. A holding period of one year is usually used.

Investors can borrow and lend at the risk-free rate of return

This is an assumption made by portfolio theory, from which the CAPM was developed, and provides a minimum level of return required by investors. The risk-free rate of return corresponds to the intersection of the security market line (SML) and the y-axis (see Figure 1). The SML is a graphical representation of the CAPM formula.

Perfect capital market

This assumption means that all securities are valued correctly and that their returns will plot on to the SML. A perfect capital market requires the following: that there are no taxes or transaction costs; that perfect information is freely available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and desire to maximise their own utility; and that there are a large...

CAPM ASSUMPTIONS

The CAPM is often criticised as being unrealistic because of the assumptions on which it is based, so it is important to be aware of these assumptions and the reasons why they are criticised. The assumptions are as follows (Watson D and Head A, 2007, Corporate Finance: Principles and Practice, 4th edition, FT Prentice Hall, pp222–3):

Investors hold diversified portfolios

This assumption means that investors will only require a return for the systematic risk of their portfolios, since unsystematic risk has been removed and can be ignored.

Single-period transaction horizon

A standardised holding period is assumed by the CAPM in order to make comparable the returns on different securities. A return over six months, for example, cannot be compared to a return over 12 months. A holding period of one year is usually used.

Investors can borrow and lend at the risk-free rate of return

This is an assumption made by portfolio theory, from which the CAPM was developed, and provides a minimum level of return required by investors. The risk-free rate of return corresponds to the intersection of the security market line (SML) and the y-axis (see Figure 1). The SML is a graphical representation of the CAPM formula.

Perfect capital market

This assumption means that all securities are valued correctly and that their returns will plot on to the SML. A perfect capital market requires the following: that there are no taxes or transaction costs; that perfect information is freely available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and desire to maximise their own utility; and that there are a large...