CAPM Assumptions

[Ludwma]

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).

Thanks,

FS

 

[David Harper CFA FRM]

Hi FS,

It is true that Elton, per answer (c), includes as the first CAPM assumption:

The first assumption we make is that there are no transaction costs. There is no cost (friction) of buying or selling any asset. If transaction costs were present, the return from any asset would be a function of whether or not the investor owned it before the decision period. Thus, to include transaction costs in the model adds a great deal of complexity. Whether it is worthwhile introducing this complexity depends on the importance of transaction costs to investors’ decisions. Given the size of transaction costs, they are probably of minor importance

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):

"The eighth and ninth assumptions deal with the homogeneity of expectations. First, investors are assumed to be concerned with the mean and variance of returns (or prices over a single period), and all investors are assumed to define the relevant period in exactly the same manner. Second, all investors are assumed to have identical expectations with respect to the necessary inputs to the portfolio decision. As we have said many times, these inputs are expected returns, the variance of returns, and the correlation matrix representing the correlation structure between all pairs of stocks."