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Are Asset Demand Functions Determined by CAPM?

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  • Jeffrey A. Frankel
  • William T. Dickens

Abstract

The Capital Asset Pricing Model (CAPH) says that the responsiveness of asset-demands to expected returns depends (inversely) on the variance-covariance matrix of returns, rather than being an arbitrary set of parameters.Previous tests of CAPM have usually computed covariances of returns around sample means, and then checked whether the riskier assets are those with the higher mean returns. We offer a new technique for testing CAPM. The technique requires the use of time series data on actual asset-holdings, and non-linear maximum likelihood estimation. We claim superiority to earlier tests on three grounds. (1) We allow expected returns to vary freely overtime.(2) The alternative hypothesis is well-specified: asset-demands are linear functions of expected returns that do not depend on the variance-covariance matrix.(3) The test-statistic has a known distribution; it is simply a likelihood ratio test. We try the technique on yearly data, 1954-1980, for household holdings of a portfolio of six assets: short-term bills and deposits, tangible assets, federal debt, state and local debt, corporate debt, and equities. Our test rejects the CAPM hypothesis.

Suggested Citation

  • Jeffrey A. Frankel & William T. Dickens, 1983. "Are Asset Demand Functions Determined by CAPM?," NBER Working Papers 1113, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:1113
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    References listed on IDEAS

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    1. Black, Stanley W, 1976. "Rational Response to Shocks in a Dynamic Model of Capital Asset Pricing," American Economic Review, American Economic Association, vol. 66(5), pages 767-779, December.
    2. Blume, Marshall E & Friend, Irwin, 1973. "A New Look at the Capital Asset Pricing Model," Journal of Finance, American Finance Association, vol. 28(1), pages 19-33, March.
    3. Ernst R. Berndt & Bronwyn H. Hall & Robert E. Hall & Jerry A. Hausman, 1974. "Estimation and Inference in Nonlinear Structural Models," NBER Chapters,in: Annals of Economic and Social Measurement, Volume 3, number 4, pages 653-665 National Bureau of Economic Research, Inc.
    4. Frankel, Jeffrey A., 1982. "In search of the exchange risk premium: A six-currency test assuming mean-variance optimization," Journal of International Money and Finance, Elsevier, vol. 1(1), pages 255-274, January.
    5. Frankel, Jeffrey & Engel, Charles M., 1984. "Do asset-demand functions optimize over the mean and variance of real returns? A six-currency test," Journal of International Economics, Elsevier, vol. 17(3-4), pages 309-323, November.
    6. William D. Nordhaus & Steven N. Durlauf, 1982. "The Structure of Social Risk," Cowles Foundation Discussion Papers 648, Cowles Foundation for Research in Economics, Yale University.
    7. Merton, Robert C, 1973. "An Intertemporal Capital Asset Pricing Model," Econometrica, Econometric Society, vol. 41(5), pages 867-887, September.
    8. Ross, Stephen A, 1978. "The Current Status of the Capital Asset Pricing Model (CAPM)," Journal of Finance, American Finance Association, vol. 33(3), pages 885-901, June.
    9. Gibbons, Michael R., 1982. "Multivariate tests of financial models : A new approach," Journal of Financial Economics, Elsevier, vol. 10(1), pages 3-27, March.
    10. Benjamin M. Friedman & V. Vance Roley, 1979. "A Note on the Derivation of Linear Homogeneous Asset Demand Functions," NBER Working Papers 0345, National Bureau of Economic Research, Inc.
    11. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, vol. 65(5), pages 900-922, December.
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    Cited by:

    1. Christopher J. Green & Victor Murinde, 2003. "Flow of funds: implications for research on financial sector development and the real economy," Journal of International Development, John Wiley & Sons, Ltd., vol. 15(8), pages 1015-1036.
    2. Jeffrey A. Frankel, 1983. "A Test of Portfolio Crowding-Out and Related Issues in Finance," NBER Working Papers 1205, National Bureau of Economic Research, Inc.
    3. Charles Engel & Jeffrey A. Frankel & Kenneth A. Froot & Anthony Rodrigues, 1989. "Conditional mean-variance efficiency of the U.S. stock market," Research Paper 8901, Federal Reserve Bank of New York.
    4. Feng, Xiaoguang, 2017. "Three essays on agricultural insurance and farm real estate investment," ISU General Staff Papers 201701010800007133, Iowa State University, Department of Economics.

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