Investments, tenth edition

  Challenges and Extensions to the CAPM 

 Which assumptions are most worrisome? We start with the fact that short positions are not 

as easy to take as long ones for three reasons:

    1.  The liability of investors who hold a short position in an asset is potentially unlim-

ited, since the price may rise without limit. Hence a large short position requires 

large collateral, and proceeds cannot be used to invest in other risky assets.  

   2.  There is a limited supply of shares of any stock to be borrowed by would-be short 

sellers. It often happens that investors simply cannot find shares to borrow in order 

to short.  

   3.  Many investment companies are prohibited from short sales. The U.S. and other 

countries further restrict short sales by regulation.    

 Why are short sales important? Notice that Assumption 1(a) begins with “investors are 

rational . . .” When investors exhibit “irrational exuberance” (excessive optimism) about 

an asset and, as a result, prices rise above intrinsic values, rational investors will take 

short positions, thus holding down the price. But with effective restrictions, short sales 

can fail to prevent prices rising to unsustainable levels that are precursors to a correction 

or even a crash. This really defines a “bubble.” 

 Three unrealistic assumptions, 2(a) (all assets trade) and 2(d) (there are no transac-

tion costs), combined with 1(b) (single-period horizon), generate the major challenges to 

the model. These challenges have motivated a set of extensions that are, even today, still 

“under construction” in one way or another. For this reason, none of the extensions has 

decisively superseded the simple CAPM in the industry. It is an impressive phenomenon, 

that despite failing many empirical tests, the compelling logic of the CAPM keeps it at the 

center of the investments industry. However, for better insight to the CAPM, it is useful to 

understand the extensions of the model.