Modern Portfolio Theory: Foundations, Analysis, and New Developments, + Website

Chapter 13

Extensions of the Standard CAPM

The CAPM presented in Chapter 12 is based on a large number of unrealistic assumptions. In this chapter and several chapters that follow, some of these assumptions are aligned to be more similar to conditions existing in the “real world.”¹ This chapter begins by reconsidering the assumptions regarding risk-free borrowing and lending, homogeneous expectations, perfect markets, and asset marketability. Then, the assumption that investors are one-period expected-utility-of-terminal-wealth maximizers is relaxed by looking at some multiperiod models. Later, in Chapter 16, several assumptions are removed simultaneously and replaced by one simple assumption. Chapter 16 derives the arbitrage pricing model and considers what happens when security returns are generated by several different risk factors.

13.1 Risk-Free Borrowing or Lending

One of the assumptions underlying the CAPM is that investors can lend and borrow an unlimited amount of money at a single riskless rate of interest. This assumption is clearly unrealistic. In the real world, it would not be difficult to lend an unlimited amount of money at the riskless rate, but almost no one can borrow at that same riskless rate of interest. Investors must borrow at a greater interest rate than the rate at which they lend (for instance, deposit savings at a bank) if money lenders are to survive. More critically, in a strict sense a truly riskless asset may not exist in the real world. This section ...