A Matter of Opinion
How the PAPM incorporates investor preferences and allows for unique forecasts.
The Capital Asset Pricing Model, or CAPM, remains the most influential model in finance, largely due to its elegant structure and powerful conclusions. The main conclusions of the CAPM are 1) all investors hold the market portfolio in combination with a risk-free asset (long or short) making optimization unnecessary and 2) the expected return in excess of the risk-free rate of each security is proportional to its systematic risk with respect to the market portfolio (beta). These conclusions, however, depend heavily on the assumptions of the model. Changing the assumptions leads to very different conclusions.
In previous issues of Quant U, I showed what happens when we separately relax or change three of the CAPM’s assumptions:1