Handbook of Market Risk

Chapter Five

The Capital Asset Pricing Model and the Arbitrage Pricing Theory

Every model is wrong, but some are useful.

—George Box

The original Capital Asset Pricing Model (CAPM) was derived by Sharpe, Lintner, and Mossin in 1964. We will consider this original model as well as extensions of it in lectures that follow. As with every other model, CAPM requires simplifying assumptions because of the complexity of the real world. There are a number of assumptions underlining the CAPM model, but only three of those are absolutely necessary for deriving the CAPM. The assumptions are as follows:

1. One-period investment horizon.

2. Rational, risk-averse investors.

3. Unlimited borrowing and lending is allowed at a risk-free rate that is the same for all investors.

4. There are no taxes.

5. There are no transaction costs and inflation.

6. All assets are infinitely divisible.

7. Free flow and instant availability of information.

8. There are many investors on the market.

9. All assets are marketable.

10. All investors have homogeneous expectations about expected returns, variances, and covariances of assets.

Also, we have shown that in the presence of a risk-free asset and under the assumptions that all individuals (i) face the same universe of assets, (ii) have the same investment horizon, and (iii) have the same expectations about future returns, variances, and covariances, and efficient portfolios will be combinations of the tangent portfolio and the risk-free asset.

Hence, we ...