assumed that a security can be completely represented in terms of its expected return and
variance and that investors behave as if a security were a commodity with two attributes,
namely, expected return which is a desirable attribute and variance which is an
undesirable attribute. Investors are supposed to be risk averse and for every additional
unit of risk they take, they demand compensation in terms of expected return.
Again, the capital market is assumed to be efficient. An efficient market implies that all
new information which could possibly affect the share prices becomes available to all the
investors quickly and more or less simultaneously. Thus in an efficient market no single
investor has an edge over another in terms of the information possessed by him since all
investors are supposedly well informed and rational, meaning that all of them process the
available information more or less alike. And finally, in an efficient market, all investors
are price takers, i.e., no investor is so big as to affect the price of a security significantly
by virtue of his trading in that security.
The Capital Asset Pricing Model also assumes that the difference between lending and
borrowing rates are negligibly small for investors. Also, the investors are assumed to
make a single period investment decisions. The cost of transactions and information are
assumed to be negligibly small. The model also ignores the existence of taxes which may
influence the investors’ behavior.
The fact that some of the above assumptions are somewhat restrictive has attracted
considerable criticism of the model. This, however, need not distract us from the main
thrust of the model. The Capital Asset Pricing Model merely implies that in a reasonably
well-functioning market where a large number of knowledgeable financial analysts
operate, all securities will yield returns consistent with their risk, since if this were not so,
the knowledgeable analysts will be able to take advantage of the opportunities for
disproportionate returns and thereby reduce such opportunities. Hence, according to
CAPM, in an efficient market, returns disproportionate to risk are difficult to come by.
Assumptions concerning the investor behavior, market efficiency, lending and borrowing
rates, etc. are to be taken not in such as taxes, transaction costs, etc. can be easily
incorporated into the model for greater rigor.