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Critically analyze the three main assumptions of the Capital Asset Pricing Model (CAPM) and why is the market portfolio efficient according to CAPM?

The Capital Asset Pricing Model was developed by William Sharpe, Jack Treynor, John Lintner, and Jan Mossin in the early 1960s. (Kenton, 2023) It is a mathematical model that estimates the expected return of an investment based on its riskiness relative to the rest of the market. (Kenton, 2023) It is a model that shows the relationship between risk and expected return on an investment.  In the CAPM model there are three main assumptions, and they are as follows:

• Perfectly competitive Markets - This means that investors can buy and sell all securities at competitive market prices without incurring taxes and can borrow at risk-free interest rates. (Berk, DeMarzo, 2020) This assumption to is a bit too much.  In actuality there is no such thing as perfectly competitive markets.  There is always going to be different factors that affect the prices of assets and markets.
• Investors hold only efficient portfolio - A perfectly efficient portfolio is one that yields the maximum expected return for a given level of volatility. (Berk, DeMarzo, 2020) This assumption to me is a bit forgiving.  Investors are human and are susceptible to emotions.
• Investors have homogeneous expectations regarding the volatilities, correlations, and expected returns of securities. (Berk, DeMarzo, 2020) - This essentially means that all investors believe the same thing when it comes to forecasting about the markets.  I find that a little hard to believe because different investors will have different views of the market.

The market portfolio is efficient according to CAPM because it represents a portfolio that offers the highest possible return at a certain level of risk.   The chart below is from Investopedia and is an example of two different portfolios.  One of which has an expected 8% return on investment with an associated 10% risk level.  The second portfolio achieves a 10% return on investment, but risk is unproportionally higher than its returns.

 

 

References

Kenton, W. (2023, June 28). What is the Capital Asset Pricing Model (CAPM)?. Investopedia. https://www.investopedia.com/terms/c/capm.asp

Berk, J., & DeMarzo, P. (2020). Corporate finance. Pearson Education Limited.

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