American Finance Association

The Market Model and Capital Asset Pricing Theory: A Note Author(s): R. C. Stapleton and M. G. Subrahmanyam Source: The Journal of Finance, Vol. 38, No. 5 (Dec., 1983), pp. 1637-1642 Published by: Blackwell Publishing for the American Finance Association Stable URL: http://www.jstor.org/stable/2327592 Accessed: 07/01/2010 07:58
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THE JOURNAL OF FINANCE * VOL. XXXVIII, NO. 5 * DECEMBER 1983

The Market Model and Capital Asset Pricing Theory: A Note

R. C. STAPLETON and M. G. SUBRAHMANYAM* ABSTRACT This note shows that a linear marketmodel is sufficientto derive a linear relationship between beta and expected return. Furthermore, slope of the relationshipwill be the identical with that of the Capital Asset Pricing Model if the return on the market portfoliois normallydistributed.However,results fromcharacterization theory suggest that the linear marketmodel assumptionis close to that of multivariatenormality.

a THE MARKET MODEL, common specification of the return-generating process for common stocks, holds a central place in financial economics.This note shows that a linear market model implies the security market line associated with the Capital Asset Pricing Model (CAPM) of Sharpe [18], Lintner [6], and Mossin [9]. However,the distributionalassumptionsimplicit in the linear market model are such that the generalizationachieved is slight. Results from characterization theory are used to show that when a linear market model with homoscedastic errorsholds for each stock, multivariatenormality is implied. The results in this note have implications for the ArbitragePricing Theory (APT) of Ross ([12], [13]) and Roll and Ross [11]. In Ross [13], where a single factor model is proposed with the return on the market as the factor, a large numbers argument is used which allows the derivation of the security market line "withoutthe additional baggageof mean variance theory."However, given similar assumptions, we show here that the same relationship can be derived without the approximationimplicit in the APT argument. I. Specifications of the Market Model Considera one-periodeconomy and let Xj and XMdenote the cash flows of firm j and the marketportfolio, respectively.Pj and PMare the currentmarket values of firm j and the aggregateof all firms, respectively, and denote R, = X/P, as the price relative of stock j. RMis similarly defined, and R is one plus the risk free rate of interest. We mean by the market model the regression
Ri = a, + #jRM + c,, E(c9) = O, E(cjRM) = O, V,

(1)

We do not make the additionalassumption that E(Cjfk) = 0 We need to note two aspects of Equation (1). First, since P, and PM are
* National WestminsterBank Professorof Business Finance, ManchesterBusiness School, and Professorof Finance, New York University,respectively.We wouldlike to thank the editor,Michael J. Brennan,and the referee,GordonSick, for their comments. 1637

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nonstochastic, (1) couldbe derivedfromthe more fundamentalstochastic relation between cash flows
X, = a, + b,XM + e,

(2)

We will use both versions (1) and (2) of the market model. Secondly, as many = authors have pointed out, the condition E(EjRM) 0 places no restrictionon the joint distributionof RJ and RMand amounts to forcing a regressionbetween the two variables. In the context of this paper, it is crucial to distinguish different levels of specification of the market model. In Section I, for example, we also assume linearity of the model. To be precise, this means
E(EjI RM) = O, V RM, R,

(3)

In Section II, we make a further specification of E,,assuming that it is homoscedastic. This can be thought of as a third-level specification and should be is distinguishedfrom a fourth case where E, independentof RM. The market model in any of these forms is a purely statistical relation while asset pricing theories have economic content. In particular,asset pricing models can be thought of as placing restrictions on a, in the unconditional expectation of (1). For instance, with a, = 0, for all j, the cross-sectional linearity of the CAPM holds, if R, and RMare interpretedas excess returns over R. We move on now to examine the implications of the market model for asset pricing. II. Asset Pricing with a Linear Market Model Many different specifications of the CAPM have been proposed.In this note we will refer to the security market line
E(Rj)
=

R + [E(RM)- R

(4)

derived originally by Sharpe [18] as the CAPM. We now show that (4) follows from basic principles of investor utility maximization if Condition (3) of the market model holds. For simplicity, assume that the preferencesof investors can be summarizedby a representativeinvestor with a utility function U(c).1 Given the assumption of a single-periodeconomy,aggregateconsumptionequalsaggregatecash flow. With the opportunityto borrowor lend at the risk-free rate, the first-orderconditions for a maximumE[U(c)] yield the pricing relations
E[U' (XM)X ]
-

PRE[U'

(XM)] =

, V,

(5) (6)

Rearranging(5) and using the definition of covarianceyields

Pj = R-1[E(Xj) + cov(X,, U'(XM))/E(U'(XM))], VJ

However,further specification of (6) to obtain the CAPM typically requiresthe assumption of quadraticutility or joint normality of X, and XM. Either assump'This assumption avoids the aggregation problem discussed by Rubinstein [16]. Equation (4) is derived by Brennan [1] and is consistent with the state preference analysis of Rubinstein [17].

Market Model and Capital Asset Pricing Theory

1639

tion implies2
P,= R-1[E(X,) where
X = -E[U"(XM)]/E[U'(XM)]
-

X cov(XJ, XM)]

(7)

Finally, using the definitions of RJ and RMand solving for the reduced form yields the returns specification of the CAPM
E(R,) = R + [E(RM) -R],S (4)

We shall show that even in the absence of either joint normality or quadratic utility (6) can still be evaluated if we use the market model. After substituting (2) in (6), the covarianceterm can be written as cov(X,, U'(XM)) = b, cov(XM, U'(XM)) + cov(e,, U (XM)) The second term in (8) above can be written as
cov(e,, U'(XM)) = E(e, U'(XM)) since

(8)

cov(e,, Xm)

0 =: cov(e,, U'(XM)) = 0

(9)

This in turn follows from the fact that E(e, I U' (Xm)) = 0 when E(e, IXm) = 0. Hence, if the market model is linear, i.e., E(ej IXm) = 0 from (3), (8) becomes3 cov(X,, U'(XM)) = b, cov(XM, U'(XM)) (10) Substituting (10) in (6) and using the least squares definition of b, yields
P, = R-1[E(X,)
-

X' cov(X,, XM)] (11)

where
X = cov(XM, U'(XM))/1[var(XM)]E(U'(XM))J

The difference between the prices in (11) and in (7), which was derived using assumptions which directly imply mean-varianceutility, is in the market price of risk. XI in (11) is no longerthe ratio of the expectedsecond and first derivatives of the representativeinvestor's utility of wealth. However, the reducedform of (11) is the CAPM relation
E(R,) = R + [E(RM) -R] O (4)

The second point to be noted is that ' in (11) reduces to X in (7) when the aggregatemarket cash flow, XM,is normallydistributed.If XMis normal4
cov(XM, U'(XM)) = E[U"(XM)] var(XM)
2 Quadratic utility implies that U' (XM) is linear in XM, allowing COV(XM, U' (XM)) to be written in terms of cov(X,, XM). Joint normality permits a similar simplification, since cov(X,, U' (XM)) = E(U" (XM)) cov(X,, XM), if X, and XM are joint normally distributed. (See Rubinstein [17]). 'This proof was suggested to us by Robert Litzenberger. A similar step is used by Kraus and Litzenberger [5] for the case of logarithmic utility functions and by Grauer et al. [3] for the general power utility function case. ' See Rubinstein [17].

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and
X = -E[U"(XM)]/E[U`(XM)
=

(12)

Thus, we are able to derive the exact prices of the CAPM with a weaker set of assumptions;XMis normally distributedand X, is a linear regressionin XMis a weaker requirementthan the joint normalityof X, and XM,for all j.5 To summarizethe conclusions of this section: (a) if the preferencesof investors can be summarizedby a representative investor and if the market model (1) holds with the linearity assumption (3), then the CAPM in Forms (4) and (11) holds. (b) if, also, RMis normally distributed,then the marketprice of risk X' in (11) is the same as in the CAPM resulting from quadraticutility or multivariate normality,namely
Xf = -E[U"(XM)]/E[U`(XM)]

III. Characterization of the Normal Distribution by the Market Model We have established that it is possible to derive CAPM type results without the usual sufficient conditions for mean varianceanalysis i.e., multivariatenormality or quadraticutility. We must consider, therefore, how different are the linearity restrictions we have imposed from the assumption of multivariate normality. The close connection between multivariate normality and the linear model has alreadybeen noted in the literature.Muth [10], for example,claims that "as long as the variates have finite variance,a linear regressionfunction exists if and only if the variates are normallydistributed";and in the context of the market model Fama [2] has shown that multivariate normality implies a linear market model for each security. It would appear then that the assumptions of linearity and multivariate normality are identical. However, Muth overstates the case since, as we discuss below in the context of the market model, a linear regressionwith constant variance exists if and only if the variables are normally distributed. Hence, it may be possible for a linear market model to hold for each security and for returns to be nonnormal if the conditional variances are not constant, i.e., heteroscedastic. The relevant theorem from characterizationtheory is due to Lukacs and Laha
[7].6 First of all, the regression (1) R=

a. + #,RM + E,, E(e,) = 0, E(E,RM)= 0

(1)

'Apart from the previous cited work of Kraus and Litzenberger [5] and Grauer et al. [3], the closest results to these in the literature are contained in Ross [15]. Ross shows that linearity is a necessary and sufficient condition for two-fund separation. The results here can be seen as an extension of Ross [15] where the additional assumption of aggregation has been used to derive equilibrium prices given that investors hold two particular funds: the market portfolio and the riskless asset. 6 This theorem is found also in Kagan et al. [4] (Theorem 5.7.1) and in Mathai and Pederzoli [8]. Another result is that, if R, and RMare linear combinations of independent, identically distributed random variables, a linear regression of R, on RM implies that the underlying variables are stable symmetric (see Ross [14]). From Lukacs and Laha [7], Theorem 6.2.9, it follows that if the factors have finite variance they must be normally distributed.

MarketModeland CapitalAsset Pricing Theory

1641

places no restriction on the joint distribution of R, and RM.However, if R, and RMcan be written as linear combinations of common independent factors, a linear regression of R, and RM with homoscedastic errors implies that the variablesare normal.7 This powerful result throws some doubt on the degree of generalization achieved in Section I. Although it may be possible to construct distributions where the market model regression is linear but heteroscedastic or where the underlyingfactors generatingreturns are not common, the degree of generalization over normality is probablyslight.8 IV. Concluding Comments This note has shown that a linear market model is a sufficient condition for derivingthe familiar CAPM linear relationshipbetween d and expected returns. Furthermore, the marketreturnis normallydistributed,the slope of the security if market line is identical to that in the mean-variance CAPM. On the negative side, characterizationtheory suggests that the difference between the assumptions of multivariatenormality and market model linearity is not great.
'Since RMis a weighted average of the R,, the factors that affect the R, must also affect RM. A more significant assumption is that all the factors that affect RM also affect R,. However, this assumption appears to be implicit in the linear market model itself. It is difficult to imagine R, being linear in RMif RMis affected by a factor which is independent of R,. 8 same comments apply to the single-factor version of the Arbitrage Pricing Theory in Ross ([12], [13]). A multifactor linear model may also imply normality if the zero mean factors are themselves independent. In this case a multifactor linear model implies a linear single-factor model. REFERENCES 1. M. J. Brennan. "The Pricing of Contingent claims in Discrete Time Models." Journal of Finance 34 (March 1979), 53-68. 2. E. F. Fama. "A Note on the Market Model and the Two-Parameter Model." Journal of Finance 28 (December 1973), 1181-85. 3. F. L. A. Grauer, R. H. Litzenberger, and R. E. Stehle. "Sharing Rules and Equilibrium in an International Capital Market under Uncertainty." Journal of Financial Economics 3 (September 1976), 233-56. 4. A. M. Kagan, Y. V. Linnik, and C. R. Rao. Characterization Problems in Mathematical Statistics. New York: Wiley, 1973. 5. A. Kraus and R. H. Litzenberger. "Market Equilibrium in a Multiperiod State Preference Model with Logarithmic Utility." Journal of Finance 30 (December 1975), 1213-27. 6. J. Lintner. "The Valuation of Risk Assets and the Selection of Risky Assets in Stock Portfolios and Capital Budgets." Review of Economics and Statistics 51 (February 1965), 13-37. 7. E. Lukacs and R. G. Laha. Applications of Characteristic Functions. New York: Hafner, 1964. 8. A. M. Mathai and G. Pederzoli. Characterization of the Normal Probability Law. New York: Wiley, 1977. 9. J. Mossin. "Equilibrium in a Capital Asset Market." Econometrica 34 (October 1966), 768-83. 10. J. F. Muth. "Rational Expectations and the Theory of Price Movements." Econometrica 29 (July 1961),315-35. 11. R. Roll and S. A. Ross. "An Empirical Investigation of the Arbitrage Pricing Theory." Journal of Finance 35 (December 1980), 1073-1103. 12. S. A. Ross. "The Arbitrage Theory of Capital Asset Pricing." Journal of Economic Theory 13 (December 1976), 341-60.

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. "Return, Risk and Arbitrage." In Risk and Return in Finance, I. Friend and J. Bicksler (eds). Cambridge, MA: Ballinger, 1977. . "Stability and Separability: The Role of the Stable Distributions in Portfolio Theory and Some Implications for Multivariate Statistical Analysis." Mimeo (January 1977). . "Mutual Fund Separation in Financial Theory-The Separating Distributions." Journal of Economic Theory 17 (April 1978), 254-86. M. Rubinstein. "An Aggregation Theorem for Securities Markets." Journal of Financial Economics 1 (September 1974), 225-44. . "The Valuation of Uncertain Income Streams and the Pricing of Options." Bell Journal of Economics 7 (Autumn 1976), 407-25. W. F. Sharpe. "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk." Journal of Finance 19 (September 1964), 425-42.