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  • Roll's Critique Is A Famous Analysis of The Validity of Empirical Tests of The

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    Raman Randhawa
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    Roll's critique analyzes the validity of testing the Capital Asset Pricing Model (CAPM). It makes two key points: 1) The CAPM equation is tautological if the market portfolio is assumed to be mean-variance efficient. 2) The market portfolio is unobservable since it would require including returns on all possible assets, both observable and unobservable. Therefore, without observing all investment opportunities, it is not possible to test whether any portfolio, including the market portfolio, is mean-variance efficient. As a result, the CAPM cannot be empirically tested.

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    Roll's critique analyzes the validity of testing the Capital Asset Pricing Model (CAPM). It makes two key points: 1) The CAPM equation is tautological if the market portfolio is assumed to be mean-variance efficient. 2) The market portfolio is unobservable since it would require including returns on all possible assets, both observable and unobservable. Therefore, without observing all investment opportunities, it is not possible to test whether any portfolio, including the market portfolio, is mean-variance efficient. As a result, the CAPM cannot be empirically tested.

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    48 views1 page

    Roll's Critique Is A Famous Analysis of The Validity of Empirical Tests of The

    Uploaded by

    Raman Randhawa
    Roll's critique analyzes the validity of testing the Capital Asset Pricing Model (CAPM). It makes two key points: 1) The CAPM equation is tautological if the market portfolio is assumed to be mean-variance efficient. 2) The market portfolio is unobservable since it would require including returns on all possible assets, both observable and unobservable. Therefore, without observing all investment opportunities, it is not possible to test whether any portfolio, including the market portfolio, is mean-variance efficient. As a result, the CAPM cannot be empirically tested.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as DOC, PDF, TXT or read online from Scribd
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    Roll's critique is a famous analysis of the validity of empirical tests of the Capital Asset Pricing Model (CAPM).

    It concerns methods to formally test the statement of the CAPM, the equation

    This equation relates the asset e pected return E(Ri) to the asset covariance !im "ith the mar#et portfolio return Rm. The mar#et return is defined as the "ealth$"eighted sum of all investment returns in the economy. %oll&s critique ma#es t"o statements regarding the mar#et portfolio' (. Mean-Variance Tautology' Any mean$variance efficient portfolio Rp satisfies the CAPM equation exactly' . Mean$variance efficiency of the mar#et portfolio is equivalent to the CAPM equation holding. This statement is a mathematical fact, requiring no model assumptions. )iven a pro y for the mar#et portfolio, testing the CAPM equation is equivalent to testing mean$variance efficiency of the portfolio. The CAPM is tautological if the mar#et is assumed to *e mean$variance efficient. Proof of Mean +ariance Tautology. ,. The Market Portfolio is Unobservable: The mar#et portfolio in practice "ould necessarily include every single possi*le availa*le asset, including real estate, precious metals, stamp collections, -e"elry, and anything "ith any "orth. The returns on all possi*le investments opportunities are uno*serva*le. .rom statement (, validity of the CAPM is equivalent to the mar#et *eing mean$ variance efficient "ith respect to all investment opportunities. /ithout o*serving all investment opportunities, it is not possi*le to test "hether this portfolio, or indeed any portfolio, is mean$variance efficient. Consequently, it is not possi*le to test the CAPM

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