Critical
assumptions of CAPM
The CAPM is simple and elegant. Consider the
many assumptions that underlie the model. Are
they valid?
 Zero transaction costs. The
CAPM assumes trading is costless so investments
are priced to all fall on the capital market
line. If not, some investments would hover below
and above the line  with transaction costs
discouraging obvious swaps. But we know that
many investments (such as acquiring a small
business) involve significant transaction costs.
Perhaps the capital market line is really a
band whose width reflects trading costs.
 Zero taxes. The CAPM assumes
investment trading is taxfree and returns are
unaffected by taxes. Yet we know this to be
false: (1) many investment transactions are
subject to capital gains taxes, thus adding
transaction costs; (2) taxes reduce expected
returns for many investors, thus affecting their
pricing of investments; (3) different returns
(dividends versus capital gains, taxable versus
taxdeferred) are taxed differently, thus inducing
investors to choose portfolios with taxfavored
assets; (4) different investors (individuals
versus pension plans) are taxed differently,
thus leading to different pricing of the same
assets.
 Homogeneous investor expectations.
The CAPM assumes invests have the same beliefs
about expected returns and risks of available
investments. But we know that there is massive
trading of stocks and bonds by investors with
different expectations. We also know that investors
have different risk preferences. Again, it may
be that the capital market line is a fuzzy amalgamation
of many different investors' capital market
lines.
 Available riskfree assets.
The CAPM assumes the existence of zerorisk
securities, of various maturities and sufficient
quantities to allow for portfolio risk adjustments.
But we know even Treasury bills have various
risks: reinvestment risk  investors
may have investment horizons beyond the Tbill
maturity date; inflation risk  fixed
returns may be devalued by future inflation;
currency risk  the purchasing power
of fixed returns may diminish compared to that
of other currencies. (Even if investors could
sell assets short  by selling an asset she
does not own, and buying it back later, thus
profiting from price declines  this method
of reducing portfolio risk has costs and assumes
unlimited shortselling ability.)
 Borrowing at riskfree rates.
The CAPM assumes investors can borrow money
at riskfree rates to increase the proportion
of risky assets in their portfolio. We know
this is not true for smaller, noninstitutional
investors. In fact, we would predict that the
capital market line should become kinked downward
for riskier portfolios (ß > 1) to reflect
the higher cost of riskfree borrowing compared
to riskfree lending.
 Beta as full measure of risk.
The CAPM assumes that risk is measured by the
volatility (standard deviation) of an asset's
systematic risk, relative to the volatility
(standard deviation) of the market as a whole.
But we know that investors face other risks:
inflation risk  returns may be devalued
by future inflation; and liquidity risk
 investors in need of funds or wishing to
change their portfolio's risk profile may be
unable to readily sell at current market prices.
Moreover, standard deviation does not measures
risk when returns are not evenly distributed
around the mean (nonbell curve). This uneven
distribution describes our stock markets where
winning companies, like Dell and Walmart, have
positive returns (35,000% over ten years) that
greatly exceed losing companies' negative returns
(which are capped at a 100% loss).
Empirical
tests of CAPM
How well does the CAPM hold up under the empirical
microscope? Testing the CAPM is difficult because
the model purports to compare expected risk
and expected return. Our observations,
however, can only be of actual results  actual
variability and actual returns. Nonetheless, if
we assume over time that expected results match
actual results, we can do some testing.
Annual Returns  Investment
Types (19261992)
Investment
type 
Nominal return 
Real return 
Risk premium
(over Tbills) 
Standard deviation 
Shortterm Tbills 
3.7% 
0.5% 
0.0% 
3.4% 
Intermediate Tbills 
5.1 
1.9 
1.4 
5.6 
Longterm Tbills 
5.4 
2.2 
1.7 
8.6 
Corporate bonds 
5.4 
2.2 
1.7 
8.5 
Largecap stocks 
10.4 
7.1 
6.6 
20.8 
Smallcap stocks 
12.1 
8.7 
8.2 
35.3 
Source: Ibbotson Associates, Stocks,
Bonds, Bills and Inflation (1992 Yearbook).
Readings
on CAPM
To get a flavor for economic studies
of CAPM, you might want to browse one of these
important articles 
 Eugene Fama & Kenneth French, The
CrossSection of Expected Stock Returns,
47 J. Fin. 427 (1992) (collecting studies)
 more recent Fama study / most downloaded on
SSRN

