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IAI Actuarial Core Principles · Economic Modelling · Capital Asset Pricing Model (CAPM)

Which of the following is an assumption underlying the standard Capital Asset Pricing Model?

The standard CAPM assumes investors hold homogeneous expectations about returns, variances and covariances. It also assumes a single common risk-free rate, no taxes or transaction costs, and a single period. The other options contradict these assumptions.

  1. AInvestors have homogeneous expectations about expected returns, variances and covariances of assetsCorrect
  2. BInvestors face different borrowing and lending rates depending on their wealth
  3. CTransaction costs and taxes affect asset choice significantly
  4. DAsset returns are assumed to be independent of each other
  5. Investors differ in their investment horizons

Explanation

CAPM assumes all investors are mean-variance optimisers with identical beliefs about the means, variances and covariances of returns, a single period, no taxes or transaction costs, and a common risk-free rate for lending and borrowing. The other options contradict these assumptions. Returns are correlated, which is why beta matters.

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