INVESTMENT ANALYSIS AND

PORTFOLIO MANAGEMENT

TOPIC: CAPM ASSUMPTIONS AND

EXTENSIONS
ASSUMPTIONS
1. Individual behavior
a. Investors are rational, mean-variance optimizers.
b. Their common planning horizon is a single period.
c. Investors all use identical input lists, an assumption often termed
homogeneous expectations.

2. Market structure
a. All assets are publicly held and trade on public exchanges.
b. Investors can borrow or lend at a common risk-free rate, and they can
take short positions on traded securities.
c. No taxes.
d. No transaction costs.
 Extensions of the CAPM

01 Identical Input lists

02 Risk - Free borrowing and the Zero-Beta Model

03 Labor Income and Other Nontraded Assets

04 Multiperiod Model and Hedge Portfolios

05 Liquidity and the CAPM

 IDENTICAL INPUT
LISTS
Assumption 1(c)
Investors all use identical input lists, an assumption often termed homogeneous
expectations. Homogeneous expectations are consistent with the assumption that all
relevant information is publicly available.

When most information is public, it would not be uncommon for investors to be close to
agreement on firms’ prospects.
Assumption 2(b) Assumption 2(c) (No taxes)
No decisive evidence that taxes are a
short positions are not as easy to take as
major factor in stock returns.
long ones for three reasons:
A plausible explanation for this negative
·The liability of investors who hold a
finding relies on “clientele” and supply
short position in an asset is potentially effects.
unlimited. a large short position clientele effect neutralizes tax effects.
requires large collateral
·There is a limited supply of shares of
any stock to be borrowed
·Many investment companies are
prohibited from short sales. The U.S.
and other countries further restrict
short sales by regulation.
Risk - Free Restrictions on borrowing can create problems for the CAPM

borrowing because borrowers and lenders will arrive at different

tangency portfolios and optimal risky portfolios.
and the Every portfolio on the efficient frontier has a portfolio on the
Zero-Beta inefficient side of the frontier with which it is uncorrelated.

Model

Expected return on the zero-beta portfolio is greater than risk-

free rate and thus the reward for bearing beta risk is smaller.
Labour income and other
nontraded assets
This extension relaxes the assumption that all
assets are traded

2 main asset classes that are not traded and

cannot be traded
Human Capital
Privately held business
Privately held business can be categorized into 2 cases
Risk characteristics similar to those of trades assets
Risk characteristics different from those of traded securities

Human capital (labour income) is more difficult to hedge using traded securities than
nontraded business. The following is the adjusted CAPM that accounts for labour income:
 Multiperiod Model and Hedge
Portfolios
The first set of assumptions pertains to investor behavior and allows us to assume that investors are alike in
most important ways, specifically that they are all mean-variance optimizers with a common time
horizon and a common set of information reflected in their use of an identical input list.

Assumption 1 a) Investors are all mean-variance optimizers

The goal of mean-variance optimization is to maximize an investment’s reward based on its risk. It states that
only the mean and variance of wealth matter to investors. The assumption rules out concern with the
correlation of asset returns with either inflation or prices of important consumption items such as housing or
energy. It also rules out concern with the correlation between asset returns and the parameters of the
“investment opportunity set,” for example, changes in the volatility of asset returns. The extra demand for
assets that can be used to hedge these “extra-market risks” would increase their prices and reduce their risk
premiums relative to the prediction of the CAPM. Similar extra-market risk factors would arise in a multiperiod
model, which we ignored when we adopted Assumption 1(b), limiting investors to a common single-period
horizon.
 CAPM assumes that there is no

transaction costs(Assumption 2d)

LIQUIDITY In reality this assumption cannot

be true. Without brokerage there

AND cannot be a trade.

CAPM Liquidity - ease and speed with

which it can be sold at fair market

value
 Asymmetric Information
Influence of
Potential for one trader to have private

Asymmetric
information about the value of the

information and
security that is not known to the

trading partner
Information

traders on bid
Information Traders
price Transactions are initiated by traders

who believe they have come across

information that a security is

mispriced
 Illiquidity and Trading cost
Illiquidity - The discount from fair market
value a seller must accept if the asset is to
be sold quickly
The discount in a security price that
results from illiquidity can be larger than
the bid–ask spread.
The price of the stock will reflect the
present value of the entire stream of
expected trading costs
High trading costs results in high illiquidity
discount.
investors with long holding periods will
hold more of the illiquid securities, while
short-horizon investors will prefer liquid
securities
 In circumstances like Financial Crisis,

2008 liquidity can unexpectedly dry

Unexpected
up

changes in
Investors demand compensation for

exposure to liquidity risk which

Liquidity modifies the CAPM expected return–

beta relationship

Firms with greater liquidity risk have

higher average returns

THANKS