Assumptions of Capital Market Theory

In continuing our theories on capital structure – an important component which isn’t discussed in the last post is the assumptions of capital market theory which builds quite well onto the Markowitz portfolio model and the assumptions of the Markowtiz model – but with some additional add ons which are unique to capital market theory. Importantly, this post assumes that because capital market theory effectively derives its roots from portfolio theory, you understand risky assets and the efficient frontier. Additionally (and indeed importantly) it is also assumed that you actually want to maximize your utility in terms of risk and return. This is of critical importance to capital market theory – choosing portfolios of risky assets on the efficient frontier at such points that your utility is tangential to the frontier. This, of course, is what Markowitz termed the efficient investor.

Ok – so what are the assumptions of Capital Market Theory (CMT)?

The assumptions of Capital Market theory are primarily eightfold and I will attempt to explain them below.

1. Everyone is an Efficient Investor – It goes without saying that everyone wants to be a efficient investor. No investor wants economic loss and all investors attempt to invest with a relative return correlated to their risk portfolio. The exact location of an investor on the efficient frontier is relative to this specific risk-return utility function and this is what return primary depends on.
2. Same Probability of Return - We must assume that all investors have the same probability distribution for future rates of return. That is, all investors want homogeneity – the same or similar future rates of return which again must be correlated to the risk-return profile.
3. Risk-Free RFR - An important assumption for the purpose of pure capital market theory is that all investors can lend or borrow money at the risk-free rate of return.
4. No Taxes or Transaction Costs - Importantly, CMT assumes that there are no transaction costs or taxes associated with the purchasing or selling of assets. The model cannot incorporate these features because they are essential dynamic measurements.
5. Fractional Components - CMT assumes that all investments can be purchased as fractional elements. That is, any investment can be purchased as a fractional component which allows the model to be illustrated graphically on a curve. Evidently, this is not possible in real life (1/4 of a share for example) but for the purposes of CMT it is assumed that it is possible otherwise exponential graphing wouldn’t occur.
6. No Inflation - There is not any inflation or changes in underlying interest rates in the pure world of CMT assumptions – there is only a reasonable initial assumption which can be modified later. Future changes cannot be modelled or rather – are not encompassed within the model.
7. Investments are purely risk-efficient - That is, that investments have a perfect risk correlation which infers that all capital markets are in equilibrium as each investment has a respective risk ratio which perfectly matches it.
8. Time Line - All investments in the CMT have a similar time-line across which they are measured. This infers that all investments are modeled within a relative time-space continuum. If investments were not measured across a similar time period then evidently other variables would change such as the measurements of risk and so forth.

Evidently, this is a whole bunch of assumptions which really begin to make one laugh at how well a model can really encompass the real world environment when so many variables are isolated. The idea of the theory is to merely measure some variables and allow us to explain asset pricing and the rates of return on assets. The entire foundation (well almost) of capital market theory is the concept that a risk-free asset exists – without this fundamental assumption there could not be a measurable comparison between risky and non-risky assets – that is, without a risk-free asset as a basis how could one formulate what is a risky asset? There would no compatible base indicator and this why it’s such a critical assumption.

What is a Risk-Free Asset exactly? That is for a future post!