There are several assumptions of the capital asset pricing model. So just a quick review remember that the CAPM formula is, the expected return of a security, otherwise known as the cost of capital. So we got the cost of capital = the risk-free rate of return + the beta of the security ⨯ the market risk premium. The market risk premium can be calculated by the expected return of the market – the risk-free rate. So this is the capital asset pricing model (CAPM).
It’s based on several critical assumptions one of those assumptions is that
- Investors are price takers
and so they buy and sell securities at competitive prices. So we’re not assuming that any person and any one person can go and have an influence over the price of a security. They’re all price takers and there are competitive prices. When investors buy and sell securities they
- Don’t incur any transaction cost or any taxes
whatsoever. So we just assume away taxes when we’re thinking about the capital asset pricing model (CAPM). We also assume that
- Investors can borrow or lend money at the risk-free rate of interest
So those are important substances but we also think about the expectations that investors have. We assume that
- Investors are homogeneous
So what that means is that we’re assuming that all the investors that are out there, that buy or sell securities, they have access to the same publicly available data. They’re all dealing with the same financial information and so forth. The same disclosures have been made by firms and so they’re going to have similar expectations when it comes to the expected rate of return the expected volatility and so forth. So when we think about risk and return we’re assuming that all the investors have the same kind of thought process because they’re all dealing with the same publicly available data for these companies. We’re not assuming that one investor knows more than another investor and therefore has very different expectations about risk and return for a company or an asset.
Then we’re also going to assume in the capital asset pricing model (CAPM) that
- The investors are only going to hold efficient portfolios of securities
and what we mean by efficient is that for any given portfolio you couldn’t go and find some other portfolio that has the risk and yet a higher return. So let me give an example as we’ve got portfolio A we got portfolio B and we look at the volatility for each portfolio and let’s say they each have a volatility of 20%. They both have the same total risk and then we look at the expected return and we see that for portfolio A the expected return is 25% and then the expected return for portfolio B is 22%.
Now think about it, why would anybody hold portfolio B when we know that they have the same risk in each portfolio and yet portfolio A has a higher return? So when we say that investors only hold efficient portfolios of securities we’re saying that in this case, they would only hold portfolio A because they have the same risk and yet they would hold the one with the highest return. It would be inefficient to hold portfolio B because you would be having the same risk as portfolio A and yet you were beginning a lower return. We’re going to assume that the investors are only going to hold efficient portfolios of securities under the capital asset pricing model (CAPM).