The result that the market portfolio is the tangency portfolio is a prediction of the CAPM model, not the market model. The market model assumes that there are two sources of risk, unanticipated macroeconomic events and firm-specific events. We use the return on the market portfolio as a proxy for the macroeconomic factor and assume all stocks have varying degrees of sensitivity to this macro factor. In addition, each stock’s returns are uniquely affected by firm-specific events uncorrelated across stocks and with the macro events. The remaining choices are the assumptions necessary to derive the single-factor market model. |
