The Capital Asset Pricing Model (CAPM) is based on the assumptions of complete agreement regarding return distributions and risk-free borrowing and lending, implying that all investors perceive the same investment opportunities and maintain similar portfolios of risky assets, but the allocation of risk-free assets could vary depending on the risk tolerance of each investor. They also combine these portfolios with risk-free borrowing or lending. Consequently, the expected return on assets uncorrelated with the market’s return should be equivalent to the risk-free rate, meaning that an asset’s expected excess return should equal the sum of the risk-free asset return and the product of its market risk (beta) and the market risk premium. The CAPM predicts a linear relationship between a portfolio’s expected return and market beta. Moreover, for the asset market to reach equilibrium, the market portfolio must be the minimum variance portfolio, and therefore, the market portfolio would be mean-variance efficient.
Early empirical studies refute the Sharpe-Lintner version of the Capital Asset Pricing Model, indicating a positive but too-flat relationship between beta and average returns (Black et al., 1972). The risk-free rate surpassed the average risk-free rate, and the coefficient on beta was lower than the average excess market return. Early investigations involving cross-sectional analysis (Fama & MacBeth, 1973) and time series regression tests (Gibbons, 1982) of the CAPM implied that standard market proxies tend to lie along the minimum variance frontier, meaning that the model’s prediction that suggests the premium per unit of beta should be the expected market return minus the risk-free interest rate was consistently rejected. More recent evidence indicated that a substantial portion of the expected return variation is unrelated to market beta. For instance, high debt-equity ratios led to returns that were disproportionately high compared to their market betas (Bhandari, 1988). Meanwhile, stocks with high book-to-market equity ratios exhibited high average returns not fully explained by their betas (Rosenberg et al., 1985). As time progressed beyond the early empirical works on the CAPM, the relationship between average return and beta for common stocks became even flatter (Lakonishok & Shapiro, 1986). On the other hand, factors including size, earnings-price, debt-equity ratios, and book-to-market ratios have been shown to contribute to the explanation of expected stock returns alongside market beta (Fama & French, 1992). Different price ratios, driven by a common factor in prices, offered similar insights into expected returns (Fama & French, 1996).
Several potential reasons could explain the disparity between the predictions of the CAPM and the empirical evidence. Firstly, from a behavioral perspective, when sorting firms based on book-to-market ratios, investors tend to overreact to favorable and adverse situations and extrapolate past performance. This overreaction was evident in stock prices that became overly inflated for growth firms and excessively deflated for distressed firms (DeBondt & Thaler, 1987; Lakonishok et al., 1994). Secondly, the CAPM, as an asset pricing model, is overly simplistic and relies on numerous unrealistic assumptions. For instance, the model assumes that investors only consider the mean and variance of one-period portfolio returns, which is a nontrivial simplification. It fails to account for the various factors influencing investors, resulting in market beta that cannot fully capture an asset’s risk, and it falls short of explaining variations in expected returns. Thirdly, there is no clear theoretical consensus on which assets could be exempt from the market portfolio. On the other side, data availability also often limits the assets that could be included, forcing the use of proxies for the market portfolio, which is argued to invalidate tests of the CAPM.
Overall, the article provides a comprehensive discussion of the CAPM, which might be a convenient theory for an early understanding of portfolio theory and asset pricing. Nevertheless, its empirical challenges might make it unsuitable for practical applications.
References
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Black, F., Jensen, M.C., & Myron Scholes. (1972). The Capital Asset Pricing Model: Some Empirical Tests, in Studies in the Theory of Capital Markets. Michael C. Jensen, ed. New York: Praeger, pp. 79–121.
De Bondt, W. F., & Thaler, R. H. (1987). Further evidence on investor overreaction and stock market seasonality. The Journal of Finance, 42(3), 557-581.
Fama, E. F., & MacBeth, J. D. (1973). Risk, return, and equilibrium: Empirical tests. Journal of Political Economy, 81(3), 607-636.
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Gibbons, M. R. (1982). Multivariate tests of financial models: A new approach. Journal of financial economics, 10(1), 3-27.
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Lakonishok, J., Shleifer, A., & Vishny, R. W. (1994). Contrarian investment, extrapolation, and risk. The journal of finance, 49(5), 1541-1578.
Rosenberg, B., Reid, K. and Lanstein, R. (1985) Persuasive Evidence of Market Inefficiency. Journal of Portfolio Management, 11, 9-17.
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