5 Assumptions Made by the CAPM

Assumptions made by the CAPM are as follows:

The CAPM makes assumptions about investor preferences (more return is preferred to less, and risk must be rewarded), about investors’ behaviour (risk is variance of the portfolio, and mean and variance of returns are the normal investor’s key considerations) and about the world (investor’s forecasts are homogeneous and markets are frictionless).


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Of the assumptions made by the CAPM, only three appear needed for the APT:

(i) Investors seek return tempered by risk: they are risk-averse and seek to ma their terminal wealth.

(ii) Investors can borrow and lend at the risk-free rate.

(iii) There are no market frictions such as transactions costs, taxes, or restriction short-selling.

These three assumptions describe investors’ behaviour in general, but fail to describe the factors on which decisions are made. That is an important difference between the two models.

The APT does not make any assumption about the distribution of the returns from assets. It does not require that investors make decisions on the basis of the mean and variance, and the troubling CAPM assumption about normalcy of returns is not necessary for the development of the APT.

The second assumption, that the risk-free rate is the minimum that an investor would accept for making an investment, is a logical part of any asset pricing model. However, the APT says nothing about the difficult problem of borrowing and lending rates.

While the APT has fewer assumptions than the CAPM, it does have two that are peculiar to it:

(iv) Investors agree on the number and identity of the factors that are important systematically in pricing assets.

(v) There are no riskless arbitrage profit opportunities.

The first of the unique APT assumptions suggests that asset returns are determined by many factors, not just “the market”, and that investors all believe these are all the factors. The second describes investors’ behaviour in the market place: they seek arbitral opportunities, and through trading strategies designed to capture the riskless profits, eliminate risk.

As a consequence, since any market equilibrium must be consistent with no arbitrage profits, every equilibrium will be characterised by a linear relationship between each asset’s expected return and its return’s response amplitude on the common factors i.e., ex ante and ex past the APT is the same.

Whereas Roll and Ross assert that a reasonable test of the CAPM must be made with the “true market portfolio”, they say that APT yields a statement of relative pricing on subsets of the universe of assets. As a consequence, the APT can be tested by examining only subsets of the set of all actual returns, i.e. it can be tested on any set of data.