e no taxes or transaction costs; 2) all investors share the same market opportunities; and 3) all investors have the same information on expected returns, volatilities, and correlations of securities available. It was found that under these assumptions Tobin’s (1958) super efficient portfolio (it consists of the risk-free asset added to Markowitz’s portfolio on the efficient frontier) must also be market portfolio.
Further on, Sharpe (1964) divided portfolio risk into systematic and specific. While systematic risk affects every asset of a portfolio (as the market moves, each individual asset is more or less affected), specific risks are unique to individual assets (it represents the component of an assets return which is uncorrelated with general market moves) and thus can be diversified in the context of a whole portfolio. In other words, the expected rate of return of a portfolio depends not on specific risks of assets, but on the systematic risk of a portfolio.
where ERi is the expected rate of return on asset i, Rf is a risk-free rate, ERm is the expected rate of return of the market portfolio, and β is systematic risk. As can be seen from the SML equation, excess return depends on beta alone and not on systematic risk plus specific risk. Moreover, the connection between rate of return and beta is linear for portfolios.
Obviously, CAPM was designed as a way to determine prices of assets in market portfolios. Indeed, given a systematic risk value and asset’s expected rate of return investor can adjust the price of an asset using the SML formula. However, because of its ‘ideal’ nature CAPM is often seen only as a theoretical tool. In practice its main assumptions are not true, and all investors have different information on risk-return characteristics of assets.
Since CAPM introduction to nowadays SML equation became a topic of wide academic discussion. Studies performed to assess the validity of CAPM can be divided into three general groups: