The Capital Asset Pricing Model in Economic Perspective
The Capital Asset Pricing Model (CAPM) is theoretically incomplete in its demandside focus, risk-averse investors, and internally inconsistent homogeneous beliefs; is not conclusively supported empirically; and yet it legitimizes 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 its 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 an internally consistent and meaningful model of competitive financial asset pricing under uncertainty, and (3) a positive-sloped shortrun supply curve based on a reasonable interpretation of 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.
|Date of creation:||Jan 2013|
|Date of revision:||Nov 2014|
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