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The capital asset pricing model: A critical literature review

Article  in  Global Business and Economics Review · January 2016

DOI: 10.1504/GBER.2016.078682

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604 Global Business and Economics Review, Vol. 18, No. 5, 2016

The capital asset pricing model: a critical literature

review

Matteo Rossi
Department of Analysis of Social and Economic System (DASES),
DEMM, University of Sannio,
Via delle Puglie, 82, 82100 Benevento, Italy
Email: mrossi@unisannio.it

Abstract: What is the relationship between the risk and expected return of an
investment? The capital asset pricing model (CAPM) provides an initial
framework for answering this question. The CAPM (Sharpe, 1964; Lintner,
1965) marks the birth of asset pricing theory. This model is based on the idea
that not all risk should affect asset prices. The model thus provides insight into
the kind of risk that is related to return. Four decades later, the CAPM is still
widely used in applications. The CAPM provides a methodology for translating
risk into estimates of expected ROE. Its application continues to generate
debate: many scholars argued that the CAPM is based on unrealistic
assumptions. This paper lays out the key ideas of the CAPM, the history of
empirical work on the CAPM and the implications of this work on the
shortcomings of the CAPM.

Keywords: capital asset pricing model; CAPM; risk; return; risk free; market
beta; market portfolio.

Reference to this paper should be made as follows: Rossi, M. (2016)

‘The capital asset pricing model: a critical literature review’, Global Business
and Economics Review, Vol. 18, No. 5, pp.604–617.

Biographical notes: Matteo Rossi is an Assistant Professor of Corporate

Finance at the University of Sannio, Italy. He earned his PhD in Corporate
Governance and his prime research interests are corporate finance, financing
innovation, wine marketing and innovation systems. In all of these areas, he has
published, contributed chapters to books, edited books and presented papers to
national and international conferences. He is the Vice President for
International Relations of the EuroMed Research Business Institute (EMRBI).
In 2014, he won the Highly Commended Paper Award of the International
Journal of Organizational Analysis (Emerald) for the paper ‘Mergers and
acquisitions in the hightech industry: a literature review’ and in 2012, he won
the Outstanding Paper Award of the International Journal of Organizational
Analysis (Emerald) for the paper ‘Italian wine firms: strategic branding and
wine performance’.

1 Introduction

Modern academic finance is built on the proposition that markets are essentially rational.
The initial model of market rationality is the capital asset pricing model (CAPM). The
CAPM developed by Sharpe (1964) and Lintner (1965), marks the birth of asset pricing

Copyright © 2016 Inderscience Enterprises Ltd.

 The capital asset pricing model: a critical literature review 605

theory. The CAPM is still widely used in applications such as estimating the cost of
capital for firms and evaluating the performance of managed portfolios.
The CAPM is a useful tool for estimating the cost of capital for firms and the returns
that investors require in investing in a company’s assets. The CAPM explains the tradeoff
between assets’ returns and their risks, measuring the risk of an asset as the covariance of
its returns with returns on the overall market. The principal prediction of the model is that
the expected return on any two assets is linearly related to the covariance of the return on
these assets with the return on the market portfolio. Each asset has two types of risk:
diversifiable, or unique, risk and non-diversifiable, or market, risk.
The attraction of the CAPM is that it offers powerful, intuitively appealing
predictions regarding how to measure risk and of the relationship between expected
returns and risk. The model is an idealised depiction of how financial markets price
securities and thereby determine expected returns on capital investments. The CAPM
provides a methodology for quantifying risk and translating it into estimates of expected
return on equity (ROE). The principal advantage of CAPM is the objective nature of the
estimated costs of equity that the model can yield. Financial managers can use it to
supplement other techniques and their own judgement in attempting to develop realistic
and useful cost of equity calculations. Although its application continues to generate
debate, modern financial theory is now applied as a matter of course to investment
management. And increasingly, problems in corporate finance are also benefiting from
use of the same techniques. Unfortunately, the empirical record of the model is poor. The
CAPMs empirical problems may reflect theoretical failings, the result of many
simplifying assumptions. However, they may also be caused by difficulties in
implementing valid tests of the model.
Although the CAPM has been subjected to extensive research and testing, researchers
have obtained with mixed findings (Sharpe, 1964; Lintner, 1965; Fama and MacBeth,
1973; Roll, 1977, 1978; Davis, 1994; Miles and Timmermann, 1996). The most
prominent works are papers by Fama and French (1992, 1993, 1995, 1996, 2004).
The CAPM has produced mixed results, giving rise to extensive debate without
yielding a systemic vision. As a result, the CAPM literature has not yet developed a
paradigm. The purpose of this paper is to present a review of existing literature.
The paper is organised as follows. The first section presents the story and logic of the
CAPM. In the second section, I review the literature on the CAPM. In a final section, I
present conclusions.

2 The story and the sense of the CAPM

The CAPM builds on the model of portfolio choice developed by Markowitz (1952). In
this model, an investor selects a portfolio at time t – 1, and the portfolio produces a
stochastic return at time t. The main assumptions of the model are
• that investors are risk adverse
• that when choosing among portfolios, investors care only about the mean and
variance of their one-period investment returns.
On this basis, investors choose ‘mean-variance efficient’ portfolios. In other words, they
choose portfolios that
606 M. Rossi

1 minimise the variance of the portfolio return, given the expected return
2 maximise the expected return, given the variance.
The portfolio model provides an algebraic condition on asset weights in mean-variance
efficient portfolios. The CAPM transforms this algebraic declaration into a testable
prediction regarding the relationship between risk and expected return by identifying a
portfolio that must be efficient if asset prices are to clear the market for all assets.
Early tests of the CAPM showed that higher stock returns were generally associated
with higher betas. These findings were taken as evidence in support of the CAPM, while
findings that contradicted the CAPM as a fully adequate model of asset pricing did not
discourage enthusiasm for the model. Miller and Scholes (1972), Black et al. (1972) and
Fama and MacBeth (1973) also demonstrated a clear relationship between beta and asset
return outcomes. Nevertheless, the returns on stocks with higher betas are systematically
less than predicted by the CAPM, while those of stocks with lower betas are
systematically higher. In response, Black (1972) proposed a two-factor model (with
loadings on the market and a zero-beta portfolio).

Figure 1 The CAPM

Source: Fama and French (2004)

Sharpe (1964) and Lintner (1965) add two key assumptions to the Markowitz model to
identify a portfolio that must be mean-variance efficient. “First, we assume a common
pure rate of interest, with all investors able to borrow or lend funds on equal terms.
Second, we assume homogeneity of investor expectations: investors are assumed to agree
on the prospects of various investments – the expected values, standard deviations and
correlation coefficients (previous) described” [Sharpe, (1964), pp.433–434].
Fama and French (2004) have described portfolio opportunities and told the CAPM
story (Figure 1).
The vertical axis shows expected return, and the horizontal axis shows portfolio risk,
measured by the standard deviation of portfolio returns. The curve abc is the minimum
variance frontier. It represents combinations of expected return and risk for portfolios of
risky assets that minimise return variance at different levels of expected return. The
tradeoff between risk and expected return for minimum variance portfolios is apparent.
 The capital asset pricing model: a critical literature review 607

An investor who wants a high expected return (point a) must accept high volatility. At
point T, the investor can have an intermediate expected return with lower volatility. If
there is no risk-free borrowing or lending, only portfolios above b along abc are
mean-variance efficient. Adding risk-free borrowing and lending turns the efficient set
into a straight line. Consider a portfolio that invests the proportion x of portfolio funds in
a risk-free security and 1 – x in some portfolio g. If all funds are invested in the risk-free
security, the result is the point Rf. This is a portfolio characterised by a risk-free rate of
return and no variance. Combinations of risk-free lending and positive investment in g
plot on the straight line between Rf and g. Points to the right of g on the line represent
borrowing at the risk-free rate: “In short, portfolios that combine risk-free lending or
borrowing with some risky portfolio g plot along a straight line from Rf through g” [Fama
and French, (2004), p.27].
To obtain the mean-variance efficient portfolios available with risk-free borrowing
and lending, one swings a line from Rf up and to the left as far as possible, to the
tangency portfolio T: all efficient portfolios are combinations of the risk-free asset and a
single risky tangency portfolio, T (Fama and French, 2004).
This result is defined by Tobin’s (1958) separation theorem. The punch line of the
CAPM is now straightforward. With complete agreement about distributions of returns,
all investors see the same opportunity set and combine the same risky tangency portfolio
T with risk-free lending or borrowing. Because all investors hold the same portfolio T of
risky assets, it must be the value-weighted market portfolio of risky assets. More
specifically, each risky asset’s weight in the tangency portfolio must be the total market
value of all outstanding units of the asset divided by the total market value of all risky
assets.
In short, the CAPM assumptions imply that the market portfolio must be on the
minimum variance frontier if the asset market is to clear. This means that the algebraic
relation that holds for any minimum variance portfolio must hold for the market portfolio.
Specifically, if there are N risky assets,

(Minimum Variance condtion for M ) E ( Ri ) = E ( RZM )

+ ⎡⎣E ( RM ) − E ( RZM )⎤⎦ βiM , i = 1, … , N .

In this equation, E(Ri) is the expected return on asset i, and βiM – the market beta of asset
i – is the covariance of its return with the market return divided by the variance of the
market return,

cov ( Ri , RM )
(Market Beta) βiM = .
σ 2 ( RM )

The first term on the right-hand side of the minimum variance condition, E(RZM), is the
expected return on assets that have market betas equal to zero. The second part is a risk
premium – the market beta of asset i – iM, times the premium per unit of beta, which is
the expected market return, E(RM), minus E(RZM). Because the market beta of asset i is
also the slope in the regression of its return on the market return, a common (and correct)
interpretation of beta is that it measures the sensitivity of the asset’s return to variations
in the market return. However, there is another interpretation of beta more in line with the
spirit of the portfolio model that underlies the CAPM. The risk of the market portfolio, as
608 M. Rossi

measured by the variance of its return (the denominator of βiM), is a weighted average of
the covariance risks of the assets in M (the numerators of βiM for different assets).
Thus, βiM is the covariance risk of asset i in M measured relative to the average
covariance risk of assets, which is just the variance of the market return. In economic
terms, βiM is proportional to the risk that each dollar invested in asset i contributes to the
market portfolio.
The last step in the development of the Sharpe-Lintner model is to use the assumption
of risk-free borrowing and lending to nail down E(RZM), the expected return on zero-beta
assets. A risky asset’s return is uncorrelated with the market return – its beta is zero –
when the average of the asset’s covariances with the returns on other assets just offsets
the variance of the asset’s return. Such a risky asset is riskless in the market portfolio in
the sense that it contributes nothing to the variance of the market return. When there is
risk-free borrowing and lending, the expected return on assets that are uncorrelated with
the market return, E(RZM), must equal the risk-free rate, Rf (Fama and French, 2004). The
relationship between the expected return and the beta then becomes the familiar
Sharpe-Lintner CAPM equation,

(Sharpe-Lintner CAPM) E ( Ri ) = R f + ⎡⎣ E ( RM ) − R f ) ⎤⎦ β iM , i = 1, … , N .

In words, the expected return on any asset i is the risk-free interest rate (Rf) plus a risk
premium, which is the asset’s market beta (βiM) times the premium per unit of beta risk,
E(RM) – Rf.
However, risk-free borrowing and lending is an unrealistic assumption. In fact, Black
(1972) develops a version of the CAPM without risk-free borrowing or lending. He
shows that the CAPM’s key result – that the market portfolio is mean-variance efficient –
can instead be obtained by allowing unrestricted short sales of risky assets. If there is no
risk-free asset, investors select portfolios from the mean-variance efficient frontier (from
Figure 1(a) to Figure 1(b)]. Market clearing prices imply that when one weights the
efficient portfolios chosen by investors by their (positive) shares of aggregate invested
wealth, the resulting portfolio is the market portfolio. The market portfolio is thus a
portfolio of the efficient portfolios chosen by investors. With unrestricted short selling of
risky assets, portfolios consisting of efficient portfolios are themselves efficient. Thus,
the market portfolio is efficient, which means that the minimum variance condition for M
given above holds, and it is the expected return-risk relationship of the Black CAPM. The
relationships between the expected return and the market beta in the Black and
Sharpe-Lintner versions of the CAPM differ only in terms of what each says about
E(RZM), the expected return on assets uncorrelated with the market. The Black version
says only that E(RZM) must be less than the expected market return, so that the premium
for beta is positive. In contrast, in the Sharpe-Lintner version of the model, E(RZM) must
be the risk-free interest rate, Rf, and the premium per unit of beta risk is E(RM) Rf.
The assumption that short selling is unrestricted is as unrealistic as unrestricted
risk-free borrowing and lending. If there is no risk-free asset, and short sales of risky
assets are not allowed, mean-variance investors still choose efficient portfolios – points
above b on the abc curve in Figure 1. However, when there is no short selling of risky
assets and no risk-free asset, the algebra of portfolio efficiency says that portfolios
consisting of efficient portfolios are not typically efficient. This means that the market
portfolio, which is a portfolio of the efficient portfolios chosen by investors, is not
typically efficient. And the CAPM relationship between expected return and the market
 The capital asset pricing model: a critical literature review 609

beta is lost. This does not rule out predictions about expected return and betas with
respect to other efficient portfolios – if theory can specify portfolios that must be efficient
if the market is to clear. However, so far, this has proven impossible.
In short, the familiar CAPM equation relating expected asset returns to their market
betas is just an application to the market portfolio of the relationship between expected
return and the portfolio beta that holds in any mean-variance efficient portfolio.
The efficiency of the market portfolio is based on many unrealistic assumptions,
including complete agreement and either unrestricted risk-free borrowing and lending or
unrestricted short selling of risky assets. However, all interesting models involve
unrealistic simplifications, which is why they must be tested against data.
“The capital asset pricing model rests on several assumptions that we did not fully
spell out” [Brealey et al., (2011), p.199]. The main limitations of the CAPM results from
its unrealistic assumptions. First of all, it is very difficult to find a risk-free security. A
short-term, highly liquid government security is considered to be risk-free. It is unlikely
that the government will default, but inflation creates uncertainty about the real rate of
return.
Another important drawback is the assumption of equality between lending and
borrowing rates. In practice, these rates differ.
The final limitation is that betas do not remain stable over time: investors have past
data about share prices and the market portfolio; they do not have the additional data
needed to estimate beta. Thus, they can estimate beta-based only on historical data.
However, most studies have shown that the betas of individual securities are not stable
over time. This implies that historical betas are poor indicators of the future risk of
securities.

3 Literature review

The empirical results regarding the CAPM in the finance literature are categorised into a
single-factor CAPM and a multifactor CAPM. The first studies (Lintner, 1965; Douglas,
1969) of the CAPM were based mainly on individual security returns and highlighted the
risk-return relationship. Their empirical results were not encouraging. In fact, both
scholars found that the intercept has values much larger than the risk-free rate of return,
while the coefficient of beta statistically has a lower value.
Miller and Scholes (1972) found the same statistical problems when using individual
securities’ returns in testing the validity of the CAPM. Additionally, other studies
overcame this problem by using portfolio returns. The first of these was conducted by
Black et al. (1972), who formed portfolios of all the stocks of the New York Stock
Exchange over the period 1931–1965. Their evidence indicates that the expected excess
return on an asset is not strictly proportional to its β: “and we believe that this evidence…
is sufficiently strong to warrant rejection of the traditional form of the model” [Black
et al., (1972), p.2] given by Sharpe (1964).
Extending the research of Black et al. (1972), Fama and MacBeth (1973) highlighted
three pieces of evidence:
• there exists an intercept term that is larger than the risk-free rate
• the linear relationship between the average return and the beta holds
610 M. Rossi

• the linear relationship holds well when the data cover a long time period.
Fama and MacBeth (1973) forming 20 portfolios of assets, validate the CAPM. Their
study, conducted on all stocks listed on the NYSE, estimates the beta using a time series
regression on the monthly data for the long period from 1935 to 1968. Their results show
that the coefficient of beta is statistically significant and that its value has remained small
over many sub-periods.
Roll (1977, 1978) raised serious doubts in testing the CAPM. Insofar as proxies are
used for the market portfolio, the Sharpe-Lintner theory is not being tested. Furthermore,
as Roll emphasises, the regression tests are probably of quite low power, and grouping
may lower the power further. These objections leave the empirical testing of the CAPM
in an odd state of limbo.
Lakonishok and Shapiro (1984, 1986) find an insignificant relationship between beta
and returns and a significant relationship between market capitalisation and returns.
Tinic and West (1984) conducted a study similar to that of Fama and MacBeth
(1973), using the same NYSE data for the period 1935–1982 but obtaining the opposite
results. In fact, they found that residual risk has no effect on asset returns. However, their
intercept is greater than the risk-free rate, and their results indicate that the CAPM might
not hold.
Subsequent studies of the single-factor CAPM (Fama and French, 1992; He and Ng,
1994; Davis, 1994; Miles and Timmermann, 1996) also provide weak empirical evidence
on these relationships.
In the early 1980s, several studies (Basu, 1977; Banz, 1981; Stattman, 1980;
Rosenberg et al., 1985; Bhandari, 1988) showed that a single-factor CAPM linear
relationship does not hold and that beta alone cannot explain the excess risk-return
relationship. For these authors, non-market factors also contribute to assets’ risk-return
relationships.
The first of these is Basu (1977), who starts from the assumption that, in an efficient
capital market, security prices fully reflect available information in a rapid and unbiased
fashion and thus provide unbiased estimates of underlying values. The purpose of his
research is “to determine empirically whether the investment performance of common
stocks is related to their P/E ratios” [Basu, (1977), p.663]. Basu finds that when stocks
are sorted on earnings-price ratios, those with high E/P have higher expected future
returns than is predicted by the CAPM.
Banz (1981) also emphasises problems linked to the use of the CAPM. In particular,
he notes that when stocks are sorted on market capitalisation (price times shares
outstanding), average returns on small stocks are higher than predicted by the CAPM.
Stattman (1980) and Rosenberg et al. (1985) showed that average cross-sectional
returns of US stocks were positively related to book-to-market (B/M) ratios. They show
that stocks with high B/M equity ratios (the ratio of the book value of a common stock to
its market value) have high average returns that are not captured by their betas.
Finally, Bhandari (1988) finds that expected common stock returns are positively
related to the ratio of debt to equity, controlling for the beta and firm size. “This
relationship is not sensitive to variations in the market proxy, estimation technique, etc.
The evidence suggests that the “premium” associated with the debt/equity ratio is not
likely to be just some kind of risk premium” [Bhandari, (1988), p.507].
All this research shows that a single factor CAPM does not hold and that other factors
also contribute to asset returns.
 The capital asset pricing model: a critical literature review 611

Chan et al. (1991), in research on a sample of Japanese firms, relate cross-sectional

differences in returns on Japanese stocks to the underlying behaviour of four variables:
earnings yield, size, book to market ratio, and cash flow yield. Their findings “reveal a
significant relationship between these variables and expected returns in the Japanese
market. Of the four variables considered, the book to market ratio and cash flow yield
have the most significant positive impact on expected returns” [Chan et al., (1991),
p.1739]. In other words, they find that book-to-market equity, BE/ME, also has a strong
role in explaining the influence of the cross-section of average returns on Japanese
stocks.
Fama and French (1992) use a more indirect approach – perhaps more in the spirit of
arbitrage pricing theory. They argue that, although size and B/M equity are not
themselves state variables, the higher average returns on small stocks and high B/M
stocks reflect unidentified state variables that produce undiversifiable risks (covariances)
in returns that are not captured by the market return and are priced separately from
market betas. They conclude that “our tests do not support the most basic prediction of
the Sharpe-Lintner-Black CAPM that average stock returns are positively related to
market betas.” However, Fama and French’s study has been criticised. Amihud et al.
(1992) and Black (1993) argue that the data are too noisy to invalidate the CAPM. These
authors show that when a more efficient statistical method is used, the estimated
relationship between average return and beta is positive and significant. In particular,
Black (1993) suggests that the size effect – noted by Banz (1981) – could be a sample
period effect (e.g., the size effect is observed in some periods and not in others).
Lakonishok et al. (1994) argue that the size and P/B effects are due to investor
overreaction rather than compensation for risk bearing. According to them, investors
systematically overreact to corporate news, unrealistically extrapolating high or low
growth into the future. This leads to underpricing of ‘value’ (small capitalisation, high
P/B stocks) and overpricing of ‘growth’ (large capitalisation, low P/B stocks). Kothari
et al. (1995) note that using historical betas estimated from annual rather than monthly
returns produces a stronger relation between return and beta. They also claim that the
relation between P/B and return observed by Fama and French (1992) and others is
exaggerated by survivor bias in the sample used and conclude: “our examination of the
cross-section of expected returns reveals economically and statistically significant
compensation (about 6 to 9% per annum) for beta risk”. Pettengill et al. (1995) find a
“consistent and highly significant relationship between beta and cross-sectional portfolio
returns”. They insist: “the positive relationship between returns and beta predicted by
CAPM is based on expected rather than realized returns”. They remark that their results
are similar to those of Lakonishok and Shapiro (1984).
Fama and French (1995) also predict that the return on the portfolio of small stocks is
higher than the return on the portfolio of large stocks (the so-called size effect) and also
that the return on stocks with high B/M ratios is higher than the return on stocks with low
B/M ratios. Fama and French (1993) take a more indirect approach, perhaps more in the
spirit of Ross’s (1976) arbitrage pricing theory (APT).
They argue that, although size and B/M equity are not themselves state variables, the
higher average returns on small stocks and high B/M stocks reflect unidentified state
variables that produce undiversifiable risks (covariances) in returns that are not captured
by the market return and are priced separately from market betas.
612 M. Rossi

Kothari and Shanken (1999) emphasise that Fama and French (1992) tend to ignore
positive evidence on historical betas and overemphasise the importance of P/B. They
claim that, while statistically significant, the incremental benefit of size, given the beta, is
surprisingly small. They also claim that P/B is a weak determinant of the cross-sectional
variation in average returns among large firms and fails to account for return differences
related to momentum and trading volume.
Elsas et al. (2000) find a positive and statistically significant relationship between
beta and return in their sample period, 1960–1995, as well as in all sub-periods they
analyse for the German market. They maintain that the empirical results provide
justification for the use of betas estimated from historical return data by portfolio
managers.
Cremers (2001) claims that the data do not provide clear evidence against the CAPM.
He argues that the poor performance of the CAPM often appears to be due to
measurement problems with respect to the market portfolio and its beta. Thus, he
concludes that the CAPM may still be valid.
Bartholdy and Peare (2001) argue that five years of monthly data and an
equal-weighted index provide the most efficient estimates of the historical beta.
However, they find that the ability of historical betas to explain differences in returns in
subsequent periods ranges from a low of 0.01% to a high of 11.73% across years. With
these results, they conclude that it may well be appropriate to declare the beta dead.
Shalit and Yitzhaki (2002) argue that the OLS regression estimator is not appropriate
for estimating betas. They suggest alternative estimators for beta: they eliminate the
highest four and the lowest four market returns and show that the betas of 75% of the
firms change by more than one standard error. Avramov (2002) shows that small-cap
value stocks appear to be more predictable than large-cap growth stocks and that model
uncertainty is more important than estimation risk: investors who discard model
uncertainty face large utility losses. Griffin (2002) concludes that country-specific
three-factor models are more useful in explaining stock returns than world and
international versions.
Koutmos and Knif (2002) propose a dynamic vector GARCH model for the
estimation of time-varying betas. They find that in 50% of cases, betas are higher during
market declines (the opposite is true for the remaining 50%). They claim that the static
market model overstates unsystematic risk by more than 10% and that dynamic betas
follow stationary, mean reverting processes.
Fama and French (2004) affirm that the failure of the CAPM in empirical tests
implies that most applications of the model are invalid. Thompson et al. (2006) present
three important pieces of evidence against the CAPM:
a the correlation between the return and the volatility of the Ibbotson Index in
1926–2000 was negative (–0.32)
b 65% of the portfolios randomly chosen had a higher return than the CAPM could
predict
c an ‘equal weight index’, in 1970–2002, had an annualised return 4.8% higher than
the S&P 500.
Aktas and McDaniel (2009) present cases in which CAPM-generated costs of equity are
less than zero, less than the risk-free rate and less than the company’s marginal cost of
 The capital asset pricing model: a critical literature review 613

debt. They calculate betas using 60 and 120 monthly returns. They reference a Compustat
database with 8,361 companies with listed betas: 925 of these are negative.
Levy and Roll (2010) affirm that many conventional market proxies could be
perfectly consistent with the CAPM and useful for estimating expected returns. This is
possible if one allows for only slight estimation errors in the return moments. They call
this data-massage “a reverse engineering approach”. They find that the minimal
variations in sample parameters are required to ensure that the proxy is mean-variance
efficient. Their research is an experiment because they use monthly returns of only the
100 largest US companies in the period December 1996–December 2006.
Brennan and Lo (2010) define ‘impossible’ as when every efficient portfolio has at
least one negative weight. They prove that the probability of an impossible frontier
approaches 1 as the number of assets increases with the sample parameters. Levy and
Roll (2011) referring to Brennan and Lo (2010), acknowledge that sample parameters
lead to an impossible frontier but observe that a slight modification of the parameters
leads to a segment of positive portfolios on the frontier.
Levy (2011) argues that, although behavioural economics contradicts aspects of
expected utility theory, CAPM and M-V remain intact in both expected utility theory and
cumulative prospect theory frameworks. Furthermore, he says that there is no evidence to
reject CAPM empirically when ex-ante parameters are employed.
Giannakopoulos (2013) finds regarding the Levy and Roll (2010) approach that
results for optimisations are sensitive to the choice of the portfolio used, the market
returns and the standard deviation as well as to the choice of the risk-free rate. They
maintain that it is possible to manipulate these results up to a point. For this reason, they
think that the performance of these models, with their real market values, is not
sufficiently robust to justify global acceptance.
Dempsey (2013) observes that much of finance is now an econometric exercise in
data mining. He concludes that the facts do not support the CAPM.
Antoniou et al. (2014) argue that the security market line accords with the CAPM by
taking an upward slope in pessimistic periods but a downward slope in optimistic periods.
In particular, high beta stocks become over-priced in optimistic periods. For this reason,
CFOs can use the CAPM for capital budgeting decisions in pessimistic periods but not
optimistic ones.
Gilbert et al. (2014) report that beta varies across return frequencies. Using returns
over the previous 60 months, they conclude that beta differences across frequencies occur
even in large and liquid stocks and cannot be explained by microstructure and trading
frictions.
A final important study was conducted by Carelli et al. (2014), who calculated the
betas of 1,385 US companies on March 31, 2014. This approach shows 147 betas for
each company, using monthly, weekly and daily returns over different intervals: from one
to five years. The median of the difference [maximum beta – minimum beta] was 1.03.
Ranking the companies according to their betas, we find that the average of the maximum
ranking – minimum ranking for the 1,385 companies is 786.
Nearly, all the papers about the CAPM published in journals in the last 48 years rely
on one calculated beta per date. Carelli et al. (2014) show that for a single date,
calculated betas have an average range of 1.03. It is easy to show that Carelli’s numbers
are correct. The conclusion of Fernandez (2014) is that most papers that use calculated
betas are irrelevant.
614 M. Rossi

4 Conclusions

This literature review indicates that the original version of the CAPM (Sharpe-Lintner
CAPM) is inadequate for explaining the risk-return tradeoff and the role that market risk
plays in the determination of stocks’ excess returns. For many researchers (Douglas,
1969; Black, 1972; Miller and Scholes, 1972; Banz, 1981; Fama and French, 1992;
Davis, 1994), the prediction of the CAPM that the market risk premium is a significant
explanatory variable in the determination of the asset risk premium is rejected. The
original version of the CAPM has never been an empirical success: “In the early
empirical work, the Black (1972) version of the model, which can accommodate a flatter
tradeoff of average return for market beta, has some success. But in the late 1970s,
research begins to uncover variables like size, various price ratios and momentum that
add to the explanation of average returns provided by beta” [Fama and French, (2004),
p.43].
CAPM is about expected return. It is clear that both, the assumptions and the
predictions/conclusions of the CAPM, have no basis in the real world (Fernandez, 2014).
The rejection of the standard CAPM as a model to explain the risk-return tradeoff is
due to a number of factors, such as incomplete information available in the markets,
investing in individual stocks rather than portfolios, and undiversified portfolios held by
investors over short observation periods.
Fama and French (2004) emphasise that there is little support for the theory’s basic
hypothesis that higher risk (beta) is associated with higher returns. To diversify away
most of the company-specific part of returns, thereby enhancing the precision of the beta
estimates, the securities are combined into portfolios to mitigate the statistical problems
that arise from measurement errors in individual beta estimates. The results obtained give
credence to the view that the linear structure of the CAPM equation is a good explanation
of security returns. The CAPM predicts that the intercept should equal zero and that the
slope should equal the excess returns of the market portfolio. The findings of a large
share of examined studies contradict the above hypothesis and provide evidence against
the CAPM. The inclusion of the square of the beta coefficient to test for nonlinearity in
the relationship between returns and betas indicates that the findings accord with the
hypothesis and that the expected return beta relationship is linear.
The use of the Sharpe-Lintner CAPM is favoured for its simplicity: it is an effective
tool for introducing the concepts of portfolio theory and asset pricing. However, “we also
warn students that despite its seductive simplicity, the CAPM’s empirical problems
probably invalidate its use in applications” [Fama and French, (2004), p.44].
This is a theoretical paper that analyses previous literature on the CAPM. In the
future, an empirical study may follow. In particular, the validity of CAPM in application
to one or more European stock markets may be examined. The purpose of these studies is
to examine the validity of the CAPM in the capital markets and to verify the theory’s
basic result that higher risk (beta) is associated with higher returns.

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