Six Simplifying Assumptions Behind Asset Pricing Models
Summary
The document outlines six assumptions used to simplify asset pricing theory, especially the Capital Asset Pricing Model: competitive and efficient markets, no taxes or transaction costs, risk-averse investors, shared expectations, normally distributed returns, and infinitely divisible assets. It explains how these premises support familiar ideas such as risk premia, diversification, mean-variance portfolio choice, and the use of return variance as a risk measure.
It also describes where the assumptions diverge from actual markets. Information is unevenly distributed, trading incurs costs and taxes, investors disagree and vary in risk tolerance, returns can be skewed or have heavy tails, and assets have minimum trading units. These conditions limit direct application of idealized models. The discussion is conceptual rather than empirical: it offers no tests of CAPM or comparisons of model performance, so the assumptions are best treated as analytical foundations whose practical relevance must be assessed in context.
Key ideas
- Asset pricing models simplify markets by assuming competition, information efficiency, and no trading frictions.
- Risk-averse investors are expected to demand compensation for bearing systematic risk.
- Shared expectations and normally distributed returns make portfolio analysis more tractable.
- Infinite divisibility allows theoretical models to assign precise portfolio weights.
- Real markets depart from these assumptions through frictions, disagreement, and non-normal returns.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.