The Capital Asset Pricing Model in Economic Perspective
AbstractThe CAPM is theoretically incomplete in its demand-side focus, risk-averse investors, and internally inconsistent homogeneous beliefs, is not conclusively supported empirically, and yet it emboldens a notion that investors can earn higher returns by bearing un-diversifiable risk. Our paper does not merely extend the CAPM with more realistic assumptions, it completes the CAPM’s original framework by including (1.) risk-taking investors in the investor population, (2.) investors who can have heterogeneous expectations or beliefs—an overlooked but required condition for the CAPM to be internally consistent and a meaningful model of competitive asset pricing under uncertainty, and (3.) a positive-sloped short-run financial asset supply curve based on a reasonable interpretation the nature of financial asset trade. Upon a complete economic interpretation, it is shown the equilibrium (systematic) risk–rate of return relationship depends on whose aggregate trading activity dominates, risk-averse or risk-taking investors’. There is no universal, or even general, positive relationship between systematic risk and rate of return. This has far-reaching implications for investors and investment advisors who serve them.
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Bibliographic InfoPaper provided by University of Connecticut, Department of Economics in its series Alumni working papers with number 2013-01.
Length: 57 pages
Date of creation: Jan 2013
Date of revision: May 2014
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economics; finance; financial economics; capital asset pricing model; CAPM; asset pricing; risk–return paradigm; investment theory; portfolio theory; theory of portfolio choice; portfolio selection; competitive asset market; perfect competition; heterogeneous beliefs; William Sharpe; John Lintner; Jan Mossin; Jack Treynor; Fischer Black; Harry Markowitz; Bernell Stone; Michael Guth; Edward Miller; Joseph Williams; Benoit Mandelbrot; Hersh Shefrin;
Find related papers by JEL classification:
- D01 - Microeconomics - - General - - - Microeconomic Behavior: Underlying Principles
- D46 - Microeconomics - - Market Structure and Pricing - - - Value Theory
- D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
- G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
- G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
- G31 - Financial Economics - - Corporate Finance and Governance - - - Capital Budgeting; Fixed Investment and Inventory Studies
- G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
- H43 - Public Economics - - Publicly Provided Goods - - - Project Evaluation; Social Discount Rate
- I30 - Health, Education, and Welfare - - Welfare, Well-Being, and Poverty - - - General
- J26 - Labor and Demographic Economics - - Demand and Supply of Labor - - - Retirement; Retirement Policies
- K22 - Law and Economics - - Regulation and Business Law - - - Business and Securities Law
- L51 - Industrial Organization - - Regulation and Industrial Policy - - - Economics of Regulation
- L84 - Industrial Organization - - Industry Studies: Services - - - Personal, Professional, and Business Services
- M21 - Business Administration and Business Economics; Marketing; Accounting - - Business Economics - - - Business Economics
- N20 - Economic History - - Financial Markets and Institutions - - - General, International, or Comparative
This paper has been announced in the following NEP Reports:
- NEP-ALL-2013-06-04 (All new papers)
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