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The Capital Asset Pricing Model in Economic Perspective

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  • Peter Dawson

Abstract

The 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 Info

Paper provided by University of Connecticut, Department of Economics in its series Alumni working papers with number 2013-01.

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Length: 57 pages
Date of creation: Jan 2013
Date of revision: May 2014
Handle: RePEc:uct:alumni:2013-01

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Keywords: 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;

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References

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  1. Vayanos, Dimitri, 1998. "Transaction Costs and Asset Prices: A Dynamic Equilibrium Model," Review of Financial Studies, Society for Financial Studies, vol. 11(1), pages 1-58.
  2. Eugene F. Fama & Kenneth R. French, 2004. "The Capital Asset Pricing Model: Theory and Evidence," Journal of Economic Perspectives, American Economic Association, vol. 18(3), pages 25-46, Summer.
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  14. Ostdiek, Barbara, 1998. "The world ex ante risk premium: an empirical investigation," Journal of International Money and Finance, Elsevier, vol. 17(6), pages 967-999, December.
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  19. John Lintner, 1965. "Security Prices, Risk, And Maximal Gains From Diversification," Journal of Finance, American Finance Association, vol. 20(4), pages 587-615, December.
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