by Brian Douglass

Created on: August 18, 2008

The Capital Asset Pricing Model (CAPM) was developed in the mid-1960s by William Sharpe, John Lintner, and Jan Mossin who built upon the portfolio management theory developed by Harry Markowitz a dozen years before (Bodie, Kane, and Marcus 1999: 251). CAPM is defined as "a set of predictions concerning the equilibrium expected returns on risky assets" (Bodie, Kane, and Marcus 1999: 251). By using CAPM, it is hoped that we can determine certain information about the relationship between an asset's risk and its expected return. This information would be useful for evaluating risky investments and even for determining if an investment is undervalued or overvalued.

In addition to the assumptions which CAPM inherits from Markowitz' model, there are an additional eight which are unique to the model. First is that all investors will use the same information to generate an efficient frontier using Markowitz' theory (Jones 1998: 226) Secondly, all investors have the same "one-period time horizon" (Jones 1998: 227). The third assumption is that all investors are able to borrow or lend money at a certain risk-free rate of return (Jones 1998: 227). Fourthly, as with Markowitz' theory, there are no transaction costs involved (Jones 1998: 227). The fifth assumption is that there are no taxes on income, this is needed because tax advantages may drive some investors to put more value on capital gains or dividends due to tax liability (Jones 1998: 227). The next assumption is that there is no inflation (Jones 1998: 227). Seventh, CAPM assumes that there are "many investors" and that no one can impact the price by their own trades (Jones 1998: 227). The final and most important assumption is that "capital markets are in equilibrium" (Jones 1998: 227).

These assumptions are hardly realistic. For example, not all investors are investing for the same time-frame. One investor may want to turn a quick profit while another is investing for retirement twenty years away. There are of course also inflation and income tax considerations for most investors. Jones, et al in Investments: Analysis and Management point out that a test of a model should not rest entirely on unrealistic assumptions. If tests of the model prove accurate, then a model is useful even if it seems to be unrealistic based on what is assumed by the model alone (Jones 1998: 227).
CAPM is built upon Markowitz' portfolio theory, so the same assumptions that underlie this theory are assumed for CAPM. These stipulate that

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