Capital Asset Pricing in a General Equilibrium Framework

The striking and powerful conclusions of the capital asset pricing model (CAPM) [13,8] arise from imposing the requirement that optimal individual portfolio decisions must be consistent with a market equilibrium for securities. That simple requirement–of market balance–produces the strong results that have been the centerpiece of research in finance in the last fifteen years. But despite the huge payoffs to imposing equilibrium requirements on financial markets, the CAP model remains a partial equilibrium result. The risks which are attributed to securities are strictly exogenous. Securities are risky because their prices fluctuate, but the cause of those price fluctuations is rarely specified. The literature seems to associate “market risk†with the business cycle and individual security risk with either random technological change or demand uncertainty. But whatever attribution is made, such risk remains outside of the model itself. Since the keystone of the CAPM is its important distinction between “real†or nondiversifiable risk and purely financial uncertainty, it is disconcerting to recognize that it is a model in which real quantities do not appear at all.