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

Chapter 15

Continuous-Time Asset Pricing Models

Although the CAPM has been a backbone in the modern finance theory, it is still subject to theoretical criticism because of the assumptions on which the model is based. One of the assumptions subject to criticism is that the CAPM is a static single-period model. That is, all investors have the same holding period. As stated by Merton (1973), implicitly, this means that the trading horizon (defined as the minimum length of time between successive trades), the decision horizon (defined as the length of time between decisions regarding investing), and the planning horizon (defined as the time interval in the investor's utility function) are all assumed to be equal to each other and to be of the same length for all investors. Critics argue that investors make their investment decisions intertemporally by maximizing their multiperiod utility of lifetime consumption, rather than choosing their portfolios according to the Markowitz mean-variance criterion to maximize their single-period utility.¹ Merton (1973) also argues that if we would expect that preferences and future investment opportunity sets are state dependent, an equilibrium model accommodating portfolio selection behavior for an intertemporal utility maximizer is needed, which will be different from the model for a single-period utility maximizer such as the CAPM.

Whereas some researchers, such as Jensen (1969), Lee (1976), Levhari and Levy (1977), and Gilster (1983), have explored ...