Research Papers in Applied Finance
(e.g., every six months). Furthermore, there is complete agreement among investors as tothe return distribution for each security or portfolio.7. There are no imperfections or frictions in the market to impede investor buyingand selling. Specifically, there are no taxes or commissions involved with securitytransactions. Thus there are no costs involved in diversification and there is nodifferential tax treatment of capital gains and ordinary income.8. There is no uncertainty about expected inflation; or, alternatively all security pricesfully reflect all changes in future inflation expectations.9. Capital markets are in equilibrium. That is, all investment decisions have beenmadeand there is no further trading without new information.Some of the above assumptions are clearly unrealistic. However, the assumptions arenot as restrictive as it appears initially and some of them can be relaxed without alteringthe basic nature of the model as we explain below. [Sears and Trennepohl (1993)]
Theoretical Implications of Relaxing the above-mentioned assumptions:
2. Inclusion of skewness (third moment) in the pricing model has led to the threemoment CAPM.4. a. Different borrowing and lending rates lead to different CAPM lines and nogeneral equilibrium pricing model. b. No riskless asset exists, leading to the zero beta CAPM, which provides for atheoretical explanation of the basic CAPM empirical results.c. There is riskless lending but no riskless borrowing, leading to the zero beta CAPM5. CAPM would be series of line segments, each representing portfolio positions withno fractional shares.6. Different expectations lead to different CAPM lines and no general equilibrium pricing model.7. a. Inclusion of transactions costs in the model would produce bands around therelationship, leading to fuzzy equilibrium.b. Consideration of taxes leads to an alternative CAPM model that incorporatesthe differential tax effects of dividends and capital gains.
Empirical Implications of Relaxing the above-mentionedAssumptions
2. The general conclusion of tests of this model indicate that skewness is important inthe pricing of securities. In particular, whenever the market portfolio is positively(negatively) skewed, investors are willing to accept (require) a lower (higher) averagereturn in exchange for positive skewness with the market portfolio.4. a. Assumption cannot be tested empirically, band c. some empirical studiessupport the zero beta CAPM, but others do not.5. Assumption has not been tested but is probably not a major empirical problem for CAPM.