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Multifactor Models Do Not Explain Deviations from the CAPM

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  • A. Craig MacKinlay
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    Abstract

    A number of studies have presented evidence rejecting the validity of the Capital Asset Pricing Model (CAPM). This evidence has spawned research into possible explanations. These explanations can be divided into two main categories - the risk based alternatives and the nonrisk based alternatives. The risk based category includes multifactor asset pricing models developed under the assumptions of investor rationality and perfect capital markets. The nonrisk based category includes biases introduced in the empirical methodology, the existence of market frictions, or explanations arising from the presence of irrational investors. The distinction between the two categories is important for asset pricing applications such as estimation of the cost of capital. This paper proposes to distinguish between the two categories using ex ante analysis. A framework is developed showing that ex ante one should expect that CAPM deviations due to missing risk factors will be very difficult to statistically detect. In contrast, deviations resulting from nonrisk based sources will be easy to detect. Examination of empirical results leads to the conclusion that the risk based alternatives is not the whole story for the CAPM deviations. The implication of this conclusion is that the adoption of empirically developed multifactor asset pricing models may be premature.

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    Bibliographic Info

    Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 4756.

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    Date of creation: Jun 1994
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    Publication status: published as Journal of Financial Economics, Vol. 38, no. 1 (1995): 3-28.
    Handle: RePEc:nbr:nberwo:4756

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    1. Roll, Richard, 1980. "Orthogonal Portfolios," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 15(05), pages 1005-1023, December.
    2. Lehmann, Bruce N, 1987. " Orthogonal Frontiers and Alternative Mean-Variance Efficiency Tests," Journal of Finance, American Finance Association, vol. 42(3), pages 601-19, July.
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    4. Ingersoll, Jonathan E, Jr, 1984. " Some Results in the Theory of Arbitrage Pricing," Journal of Finance, American Finance Association, vol. 39(4), pages 1021-39, September.
    5. Andrew W. Lo & A. Craig MacKinlay, 1989. "Data-Snooping Biases in Tests of Financial Asset Pricing Models," NBER Working Papers 3001, National Bureau of Economic Research, Inc.
    6. Kandel, Shmuel & Stambaugh, Robert F, 1989. "A Mean-Variance Framework for Tests of Asset Pricing Models," Review of Financial Studies, Society for Financial Studies, vol. 2(2), pages 125-56.
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    15. Shmuel Kandel & Robert F. Stambaugh, 1991. "Asset Returns and Intertemporal Preferences," NBER Working Papers 3633, National Bureau of Economic Research, Inc.
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    Cited by:
    1. Chen, Long & Petkova, Ralitsa & Zhang, Lu, 2008. "The expected value premium," Journal of Financial Economics, Elsevier, vol. 87(2), pages 269-280, February.

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