Capital Asset Pricing Model (CAPM), introduced by William Sharpe, John Lintner, and Jan Mossin, is a widely used framework for estimating the expected return of an asset based on its risk. The Single-Period Classical CAPM Model is based on a set of assumptions that simplify market conditions for investors.
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Investors are Rational and Risk-Averse
CAPM assumes that investors act rationally and prefer higher returns with lower risk. They choose investment portfolios based on the mean-variance optimization framework introduced by Markowitz. Since investors are risk-averse, they demand a higher return for taking on additional risk. This risk is measured using beta (β), which indicates how an asset’s returns move relative to the market. If an asset has a higher beta, investors expect higher returns as compensation for higher risk exposure.
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Single-Period Investment Horizon
The model assumes that all investors have a single-period investment horizon (e.g., one year). This means they make investment decisions for a fixed time frame and then reassess their portfolios at the end of the period. This simplifies the pricing mechanism since investors are not concerned with changing expectations over time. The single-period assumption ensures that investors analyze risk and return only within a defined period, making it easier to derive an optimal portfolio.
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Investors Have Homogeneous Expectations
All investors in the market have the same expectations regarding future returns, volatility, and correlations of assets. This assumption means that given the same set of market information, all investors would choose the same optimal portfolio. Since every investor agrees on the expected returns, variances, and covariances, they derive identical estimates for the market portfolio. This leads to the Capital Market Line (CML) and the Security Market Line (SML) as guides for portfolio selection.
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No Taxes and Transaction Costs
CAPM assumes a perfect market where there are no transaction costs, brokerage fees, or taxes. This simplifies the investment process because investors can buy and sell assets freely without incurring additional costs. In reality, taxes and transaction fees affect investment decisions by reducing net returns, but in CAPM, these factors are ignored to focus only on systematic risk and expected returns. This assumption helps in deriving a pure risk-return relationship.
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Risk-Free Borrowing and Lending
Investors are assumed to have access to risk-free borrowing and lending at a constant risk-free rate (R_f). This means they can borrow unlimited amounts at the same rate as the risk-free asset, enabling them to create leveraged portfolios. Investors who are more risk-averse can allocate more to the risk-free asset, while aggressive investors can borrow money to invest in riskier assets. This assumption allows the development of the Capital Market Line (CML) for portfolio selection.
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Market is in Equilibrium
CAPM assumes that the market is always in equilibrium, meaning that asset prices correctly reflect all available information. No investor can earn abnormal returns (excess profits) in the long run because prices adjust immediately to new information. This assumption aligns with the Efficient Market Hypothesis (EMH), which states that all securities are fairly priced based on their risk levels. Since investors cannot consistently beat the market, they must accept the return dictated by their risk exposure.
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Market Portfolio is Efficient and Includes All Assets
CAPM assumes that investors hold the market portfolio, which includes all available risky assets in proportion to their market value. This market portfolio is fully diversified, eliminating all unsystematic risk (company-specific risk). Since the market portfolio is on the efficient frontier, any asset’s expected return depends only on its systematic risk (β). Investors combine the risk-free asset with the market portfolio to form their optimal portfolios based on risk tolerance.
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Investors Can Trade Any Asset Without Restrictions
CAPM assumes that all assets are infinitely divisible and can be traded freely without any restrictions. There are no short-selling constraints, meaning investors can sell assets they do not own if needed. In reality, some markets have liquidity constraints and regulations that prevent certain trades. However, in the CAPM framework, these restrictions do not exist, allowing investors to construct any portfolio combination freely based on their risk-return preferences.