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:

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 ...

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