CAPM Assumptions

Discussion in 'P1.T1. Foundations of Risk (20%)' started by Ludwma, May 16, 2012.

  1. Ludwma

    Ludwma Member Subscriber

    John Simpson, FRM, is debating whether or not the capital asset pricing model (CAPM) is an appropriate technique for estimating the equity required rate of return for a publicly traded company. The CAPM in practice is subject to which of the following limiting assumptions?

    a. Only large stock indices provide appropriate market return expectations.
    b. Investors must have the same expectations regarding the mean, standard deviation, and probability distribution of expected returns.
    c. Transaction costs do not exist.
    d. Investors must be both risk-averse and risk-neutral.

    The asnwer is b. Not clear why not c (or b).


  2. David Harper CFA FRM

    David Harper CFA FRM David Harper CFA FRM (test) Staff Member

    Hi FS,

    It is true that Elton, per answer (c), includes as the first CAPM assumption:
    But I sort of do like the question because, as I say in my video, I think homogeneity is the most critical and audacious (unrealistic) assumption. Homogeneity is required for the equilibrium that fancifully gets all investors to agree on the same Market portfolio. CAPM pretty much falls apart without out, and at the same time, it's hard to believe it could be true (imo):
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