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Capital Asset Pricing Model

Part 2: The Empirics

RECAP: Preference
2) 5 Axioms for Expected Utility
Expected Return E(Rp)
3) Prefer more to less (Greedy)
4) Risk aversion
5) Assets jointly normally

Increasing Utility

Standard Deviation
σ(R )
RECAP: Min-Variance opp. set
E(Rp) - Portfolios along the efficient
set/frontier are referred to as
“mean-variance” efficient

Individual risky assets

Min-variance opp. set

RECAP: Capital Market Line
(a.k.a Linear efficient set)


2) Homogenous Belief
3) Unlimited Lending/borrowing

RECAP: 2-fund separation
Everyone’s U-maximizing portfolio consists of a combination of 2
assets only: Risk-free asset and the market portfolio. This is true
irrespective of the difference of their risk-preferences


(M) Market Portfolio

CML Equation:
A E(Rp) = Rf + [(E(RM)- Rf)/σM]σ(Rp)


E(return) = Risk-free rate of return + Risk premium specific to asset i
= Rf + (Market price of risk)x(quantity of risk of asset i)
E(Ri) E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)]
E(Ri) = Rf + [E(RM)-Rf] x βi


slope = [E(RM) - Rf] = Eqm. Price of risk

βM = 1 βi = COV(Ri, RM)/Var(RM)
Empirical Studies of CAPM
• Is CAPM useful?
– Given many unrealistic assumptions, how good does the model
fit into the reality?

• Think about the following questions:

[1] What exactly are the predictions of the CAPM?
[2] Are they testable?
[3] What is a regression?
[4] How to test hypothesis? What is t-test?
[1] What are the predictions ?
[a] CAPM says: more risk, more rewards
[b] HOWEVER, “reward-able” risk ≠ asset
total risk, but = systematic risk (beta)
[c] We ONLY need Beta to predict returns
[d] return LINEARLY depends on Beta
[2] Testable ?
E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)]
E(Ri) = Rf + [E(RM)-Rf] x βi

Ideally, we need the following inputs:

[a] Risk-free borrowing/lending rate {Rf}
[b] Expected return on the market {E(RM)}
[c] The exposure to market risk
{βi = cov(Ri,RM)/var(RM)}
[2] Testable ?
E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)]
E(Ri) = Rf + [E(RM)-Rf] x βi

In reality, we make compromises:

[a] short-term T-bill (not entirely risk-free) {Rf}
[b] Proxy of market-portfolio (not the true
market) {E(RM)}
[c] Historical beta
{βi = cov(Ri,RM)/var(RM)}
[2] Testable ?
Problem 1:
What is the market portfolio? We never truly
observe the entire market.
We use stock market index to proxy market,
[i] only 1/3 non-governmental tangible assets
are owned by corporate sector. Among them,
only 1/3 is financed by equity.
[ii] what about intangible assets, like human
[2] Testable ?
Problem 2:
Without a valid market proxy, do we really
observe the true beta?
[i] suggesting beta is destined to be estimated
with measurement errors.
[ii] how would such measurement errors bias
our estimation?
[2] Testable ?
Problem 3:
Borrowing restriction.

Problem 4:
Expected return measurement.
[i] are historical returns good proxies for future
expected returns? Ex Ante VS Ex Post
[3] Regression
E(Ri) = Rf + [E(RM)-Rf] x [COV(Ri, RM)/Var(RM)]
E(Ri) = Rf + [E(RM)-Rf] x βi
E(Ri) – Rf = [E(RM)-Rf] x βi
With our compromises, we test :
[Ri – Rf] = [RM-Rf] x βi
Using the following regression equation :
[Rit – Rft] = γ0 + γ1βi + εit
In words,
Excess return of asset i at time t over risk-free rate
is a linear function of beta plus an error (ε).
Cross-sectional Regressions to be performed!!!
[3] Regression
[Rit – Rft] = γ0 + γ1βi + εit

CAPM predicts:
[a] γ0 should NOT be significantly different
from zero.
[b] γ1 = (RMt - Rft)
[c] Over long-period of time γ1 > 0
[d] β should be the only factor that explains
the return
[e] Linearity
[4] Generally agreed results
[Rit – Rft] = γ0 + γ1βi + εit

[a] γ0 > 0
[b] γ1 < (RMt - Rft)
[c] Over long-period of time, we have γ1 > 0
[d] β may not be the ONLY factor that explains the
(firm size, p/e ratio, dividend yield, seasonality)
[e] Linearity holds, β2 & unsystematic risk become
insignificant under the presence of β.
[4] Generally agreed results

[Rit – Rft]
CAPM Predicts


γ1 = (RMt - Rft)
γ0 = 0 βi
Roll’s Critique
Message: We aren’t really testing CAPM.

Argument: Quote from Fama & French (2004)

“Market portfolio at the heart of the model is theoretically and

empirically elusive. It is not theoretically clear which assets (e.g.,
human capital) can legitimately be excluded from the market
portfolio, and data availability substantially limits the assets that
are included. As a result, tests of CAPM are forced to use
compromised proxies for market portfolio, in effect testing whether
the proxies are on the min-variance frontier.”

Viewpoint: essentially, implications from CAPM aren’t independently

testable. We do not have the benchmark market to base on. Every
implications are tested jointly with whether the proxy is efficient or