2011pbfeam 112
2011pbfeam 112
2011pbfeam 112
, (1)
where, =
-1
(R-r) and can be rewritten as = c
, is a nx1 vector =
-1
(R-r)/
[e
T
-1
(R-r)], c
= e
T
-1
(R-r) =
T
(R-r)/
T
is a constant scalar, e
T
is 1xn vector of
one. Since e
T
=1, is interpreted as a portfolio in this paper.
The R-r = c
-1
(R-r)] .
On the other hand, the CAPM is presented as the following:
R
i
= r +
i
(R
m
-r), for all i=1,2,,n (2)
where, R
m
r is the market risk premium,
i
= Cov( R
~
m
, R
~
i
)/
m
2
, Cov(.,.) is the
covariance operator,
m
is the market portfolio, R
m
is the expected rate of return on the
market portfolio R
~
m
=
m
T
R
~
, and
m
2
is the variance of the market portfolio rate of
return
.
In equation (2), the
i
is defined by
i
= E[(
R
~
m
-R
m
)(
R
~
i
R
i
)] /
m
2
, where, E[..] is
the expectation operator in statistics. The definition of
i
implies that the expected rate of
return R
i
and R
m
on the asset i and on the market portfolio, respectively, must be given
before the
i
can be calculated. That is, using systematic risk
i
to explain the R
i
in the
CAPM is implausible in statistics because the R
i
exists already before the beta appears.
In terms of vector algebraic, equation (2) can be rewritten as
R
- r = (R
m
r) =(R
m
r)
m
/
m
2
= c
m
m
=
m,
(3)
9
Where, =
m
/
m
2
, c
m
= (R
m
-r)/
m
2
,
m
= c
m
m
, is the nx1 vector of beta,
m
is the
nx1 vector of covariance between the rate of return on i-th risky asset
i
R
~
i=1,2,,n and
the market portfolio rate of return
m
R
~
,
m
2
=
m
T
m
.
Equations (1) and (3) imply that =
-1
(R-r)=
m
and thus the market portfolio
8
m
in equation (3) must be identical to the unique portfolio
-1
(R-r)/[e
T
-1
(R-r)] = in
equation (1). That is, equation (3) must be identical to equation (1). Since equation (1)
holds for any positive integer n, thus, equation (3) must hold for any number of assets as
well once the expected rate of return and their covariance existent or being given.
Equation (1) is simply an algebraic result and is irrelevant to the demand and
supply of the risky assets. Therefore, equation (1) must be irrelevant to market
equilibrium. Since equation (1) is identical to equation (3), the market equilibrium must
be irrelevant to the CAPM. Hence, the required rate of return on an asset based on the
market equilibrium in the CAPM must be identical to the assumed expected rate of return
on an asset in equation (1).
In addition, the matter of equation (3) is the optimal mean-variance efficient
portfolio for n securities rather than the market equilibrium. In other words, previous
studies substitute the unobservable mean-variance efficient portfolio by the market
portfolio under the equilibrium condition in the CAPM is not justifiable. Unfortunately,
Elton et. al(2010), Fama and French (2004) argue that if all investors select the same
10
optimal portfolio, then, in equilibrium, the portfolio must be a portfolio in which all
securities are held in the same percentage that they represent in the market value. This
could overstate the role played by the market portfolio in the CAPM because, as shown in
equations (1) and (3), the relationship of R
- r = (R
m
r) always hold for any n assets
once the portfolio is constructed by these n assets and is satisfied
m
=
-1
(R-r)/[e
T
-1
(R-
r)]. Therefore, the exact market portfolio could be redefined clearly. Is it constructed by
all securities in the market with the ex post market value weighted or by a finite number
of securities with the optimal mean-variance efficient as presented by in equation (1)?
Similarly, as shown in equations (1) and (3), the investors risk preference or
utility function and the unlimited risk-free rate lending and borrowing, the joint normal
density function, and a perfect market are all irrelevant to derive the CAPM.
Since the ex ante expected rates of return are assumed to be given and exist before
the beta is constructed and appears in the CAPM, there is no rationale to use the ex post
systematic risk in equations (2) and (3) to explain the already existent ex ante expected
excess rate of return. Therefore, if the CAPM were valid, then the expected excess rate of
return would have depended on the portfolio
m
, which affects the beta or systematic risk
and depends on the expected excess rate of return. This leads a mathematical problem
that the expected excess rate of return on an individual security is a function of the
expected rate of return on the market portfolio, which depends on the expected excess
rate of return on the asset. In other words, the expected excess rate of return on securities
11
R-r depend on itself; the expected excess rate of return on securities. Equation (3) proves
the following proposition.
Proposition 2: Given the expected excess rate of return vector R-r and non-singular
covariance matrix between the risky securities returns, the CAPM holds if and only if
the market portfolio
m
=
-1
(R-r)/[e
T
-1
(R-r)]
9
.
The implication of the Propositions 1 and 2 is that if the market portfolio is not
the optimal mean-variance efficient portfolio, then equation (1) and the CAPM fail and
the CAPM is invalid. In other words, the CAPM is equivalent to that the market portfolio
is the optimal mean-variance efficient. Thus, to test the CAPM is equivalent to test the
optimal mean variance efficiency of the market portfolio
m
. Since the components of
means and the covariance between n risky securities returns are unobservable, the
optimal mean-variance efficiency of market portfolio
m
must be unobservable as well.
As shown in Proposition 2, the optimal mean-variance portfolio
m
is irrelevant to the
market and thus is not a real market portfolio. However, to facilitate the following
exploration of the CAPM, the
m
in the CAPM still stands for market portfolio for the
rest of this paper
Since the portfolio
m
in equation (3) depends on the expected excess rate of
return on assets and the covariance among the assets return, the weights of the portfolio
m
must be changed if randomly appearing information (e.g., earning surprise or other
events) causes the changes of the parameters such as expected rate of returns or the
covariance on the assets. Furthermore, equation (1) fails for all portfolios on the mean
12
variance efficient frontier except the optimal one. That is, the
m
in the CAPM is not just
the mean variance efficiency but also the optimal one.
Proposition 2 shows that the market portfolio
m
in the CAPM should only be
restricted to its components and its composition must be decided by
-1
(R-r)/[e
T
-1
(R-
r)]. In other words, if the assets are excluded in the construction of
m
, the CAPM (or
equation (2) or (3)) should not apply to these risky assets even though these assets are in
the market. For example, consider an asset with ex ante positive expected excess rate of
return, the expected excess return on this asset calculated by the CAPM should be zero if
this asset was absent in the composition of the portfolio
m
and its rate of return is
uncorrelated to the rate of return on the portfolio
m
. This example demonstrates that the
CAPM is a misspecification model when it is applied to assets excluding from the
construction of the portfolio
m
in equation (3).
The unobservable nature of the market portfolio should be attributed to the
unobservable population parameters of the expected excess rate of return R-r and the
covariance in for these n risky securities rather than all risky assets in the market.
Thus, the claim that the market portfolio in the CAPM includes the non-tradable and
human capital assets is not sustainable from the construction of
m
as shown in the
Proposition 2.
III. In the CAPM, the Greater Expected Rate of Return on an Asset, the Greater
Beta
13
Both of the beta and the market risk premium are vital factors for the expected excess rate
of return in the CAPM. The beta is the core variable in the CAPM that affects the
expected excess rate of return on the assets. In the CAPM, only the assets non-
diversifiable systematic risk merits a reward for the assets expected excess rate of return.
The beta represents the systematic risk and is defined as the ratio of the covariance
between the market rate of return and the security rate of return to the variance of market
rate of return. From Proposition 2, the market portfolio
m
is equal to
-1
(R-r)/[e
T
-1
(R-
r)], thus the beta in the CAPM can be rewritten in terms of the vector algebraic as;
=
m
/
2
=
-1
(R-r)/[e
T
-1
(R-r)
2
] = (R-r)/(c
m
2
). (4)
Since c
m
2
is a constant, equation (4) demonstrates the beta in the CAPM
depends on and is proportional to the expected excess rate of return on asset rather than
an independent variable of the systematic risk related to the covariance between the rate
of return on assets and the return on the market portfolio. The greater expected rate of
return results in a greater beta, which completely contradicts the assertion of the CAPM
that a higher beta should have a higher expected return to compensate the risk taking of
the investors.
Furthermore, as shown in the last term of equation (4), the feature of the beta as
the measure of the systematic risk disappears because the is irrelevant to the covariance
between the market portfolio rate of return and the assets rate of return. In other words,
the beta in the CAPM is completely irrelevant to the systematic risk if the market
14
portfolio is the mean-variance efficient as shown in equation (3). That is, there is no such
thing as systematic risk in the CAPM if market portfolio
m
=
-1
(R-r)/[e
T
-1
(R-r)].
Therefore, the discount rate on a project in corporate finance is a function of the projects
beta is not sustainable from equation (4) . Unfortunately, the beta has been misinterpreted
as the systematic risk in the CAPM for the last four decades. Equation (4) proves the
following Proposition:
Proposition 3: In the CAPM, if the market portfolio
m
is equal to
-1
(R-r)/[e
T
-1
(R-
r)], then the beta depends on the expected excess rate of return, not vice versa. The
greater the expected return the greater the beta rather than the greater beta the higher the
expected rate of return.
IV. The Market Risk Premium is Irrelevant to the Investors Risk Preference
The other vital factor for the R-r in the CAPM is the market risk premium R
m
-r, which is
defined as the product of the market portfolio
T
m
and the vector of expected excess rate
of return R-r. Thus, the market risk premium R
m
-r can be presented as
R
m
- r =
T
m
(R-r) = (R-r)
T
-1
(R-r)/[e
T
-1
(R-r)]. (5)
Equation (5) shows the market risk premium is computed by the already existent
ex ante population parameters
10
; the expected rate of returns and the covariance between
the stochastic rate of returns. Once the expected excess rate of return and the covariance
in the are given, the market risk premium R
m
-r is set and fixed. The risk preference of
15
investors in the market plays no role in determining the market risk premium. Equation
(5) shows the following proposition.
Proposition 4: In the CAPM, the market risk premium R
m
-r is solely determined by the
parameters of the expected excess rates of returns and the non-singular covariance matrix
between the risky asset returns if the market portfolio is equal to
-1
(R-r)/[e
T
-1
(R-r)]
rather than by the risk preferences of investors in the market.
V. The CAPM is a Tautology
In statistics, if the rate of return on an asset is not conditional on the market rate of return
at the beginning of the model setting
11
, the ex ante expected rate of return on an asset in
the CAPM must be a constant and should be decided by its density function only. Hence
the ex ante constant expected rate of return on an asset should not depend on other
parameters or variables such as the systematic risk or the market risk premium.
To proves mathematically why the CAPM is a tautology? We assume the
covariance matrix is invertible, the vector of the expected excess rate of return R
- r in
the CAPM can be rewritten as
R
- r =
-1
(R-r) = [e
T
-1
(R-r)]
-1
(R-r)/[e
T
-1
(R-r)]
= [e
T
-1
(R-r)]
m
= c
m
m
= (R
m
-r)
m
/
m
2
= (R
m
-r) (6)
16
where, as defined in equation (2),
m
=
-1
(R-r)/e
T
-1
(R-r), c
m
= (R
m
-r)/
m
2
= e
T
-1
(R-
r), and =
m
/
m
2
.
Equation (6) shows that the constant expected excess rate of return R-r on an
asset can be rewritten in different forms such as
-1
(R-r) and (R
m
-r), which is exactly
the CAPM. Since (R
m
-r) is just a rewritten of the expected excess rate of return on assets
R-r, the CAPM must be a tautology and mathematically invalid as an asset pricing
model. Despite its invalidity in mathematics, surprisingly, the CAPM has been
extensively used as the basic model in different areas since it was developed four decades
ago. Equation (6) proves the following proposition.
Proposition 5: Given the expected excess rate of return vector R-r and non-singular
covariance matrix between the risky securities returns, the CAPM is a tautology if and
only if the market portfolio
m
=
-1
(R-r)/[e
T
-1
(R-r)]. If the market portfolio
m
-
1
(R-r)/[e
T
-1
(R-r)], then the linear relationship between the expected rate of return on an
asset and its beta in the CAPM fails and the CAPM is invalid
12
.
Equation (6) hold for any finite n securities, n=1,2,3,..,n, it should also hold for
any subsets of the capital market securities once the expected return and invertible
covariance between all other securities returns in the subset are available. A tautology
model is useless from all its aspects, hence, the CAPM should not be exaggerated and
overstated its applications to all areas in finance.
17
In practice, the proxy for the market portfolio is the market index, which is
constructed with different size and weight at the time of the index being created.
Regardless it is weighted and/or its size, the observable market indices are fixed per se
and independent of the expected excess rate of return on assets and the covariance
between n assets returns in the future. This implies that the CAPM fails as shown in
Proposition 5 if the market index is not exactly equal to the optimal mean-variance
efficient portfolio
m
. In other words, if the market index is not the mean-variance
efficient and is used to substitute for the optimal mean-variance market portfolio
m
, the
linearity between the expected excess rate of return and the beta calculated by this market
index is not sustainable as argued by Roll and Ross (1994). This could also be one of the
reasons why such poor coefficient of determination R
2
occur when testing the CAPM
simply because the researchers used a mean-variance inefficient market index instead of
the mean-variance efficient market portfolio in their studies. The other reason for poor
empirical results in testing the CAPM could be applying the CAPM to assets which are
excluded in the construction of the market portfolio (or market index).
A numerical example can clearly demonstrate these results. Assume n=2, and the
vector of the ex ante expected excess rate of return and the covariance matrix
13
are given,
respectively, by the following:
18
9 3
3 4
10
5
, ) r R (
. The inverse matrix
-1
, the in equation (1), and the c
m
in equation (2) are
calculated, respectively, by
1
]
1
1
]
1
,
_
,
_
25
15
27
1
10
5
4 3
3 9
27
1
) ( ,
4 3
3 9
27
1
1 1
r R
.
( )
27
40
25
15
1 1
27
1
) (
1
1
]
1
r R e c
T
m
,
The unique mean variance efficient portfolio in equation (1), which must be the same
of the market portfolio
m
in this example, is determined by
19
1
]
1
1
]
1
8 / 5
8 / 3
) 27 / 40 /(
25
15
27
1
) (
) (
1
1
r R e
r R
T
m
.
Here, the
m
is totally irrelevant to the market value of the assets. The market risk
premium R
m
-r, the variance of the market portfolio rate of return
m
2
, and the beta are
calculated, respectively, by
( )
8
65
10
5
8 / 5 8 / 3 ) (
1
]
1
r R r R
T
m m
,
20
( ) ( )
64
351
8 / 54
8 / 27
8 / 5 8 / 3
8 / 5
8 / 3
9 3
3 4
8 / 5 8 / 3
2
1
]
1
1
]
1
,
_
m
T
m m
,
1
]
1
1
]
1
13 / 16
13 / 8
) 64 / 351 /(
8 / 54
8 / 27
2
m
m
.
Under two risky assets n=2, the CAPM is presented by
21
8
65
13 / 16
13 / 8
) ( ) (
) (
) (
) ( ) (
10
5
2 1
1
1 1
1
]
1
1
]
1
r R r R c
r R e
r R
r R e r R r R
m
m
m
m m m
T
T
This numerical example shows that (i) the given constant expected excess rate of
return can be rewritten in different forms including the product of the beta and the
market risk premium R
m
-r, (ii) given the covariance matrix , the optimal mean-variance
market portfolio
m
, beta, and market risk premium all are constructed and calculated by
the given expected excess rate of return, (iii) the CAPM is just an algebraic result once
the expected excess rate of return and the non-singular covariance matrix are given, (iv)
the CAPM is a tautology if the mean variance efficient portfolio is used in the CAPM,
and (v) the CAPM is useless as a reliable model because the constant parameter of the
expected excess rate of return exists before the market portfolio, beta, and market risk
premium are created.
22
Under the same expected rate of return and the covariance matrix, if the market
index is value-weighted by
T
x
= (1/3, 2/3), then the market risk premium R
x
-r, variance,
and beta
x
under this market index are calculated, respectively, by
R
x
- r
3
25
10
5
3 2 3 1 / / ) r R (
T
x
,
9
52
3 21
3 10
3 2 3 1
3 2
3 1
9 3
3 4
3 2 3 1
2
/
/
/ /
/
/
/ /
x
T
x x
,
23
52 63
52 30
9 52
3 21
3 10
2
/
/
) / /(
/
/
x
x
x
.
The CAPM with the mean-variance inefficient market index is
. r R
/
/
/
/
) r R (
x x
10
5
52 525
52 250
3
25
52 63
52 30
24
This demonstrates that if the optimal mean-variance efficient market portfolio is
substituted for a non-optimal mean-variance efficient index regardless how it was
weighted, the required rate of return will be miscalculated by the product of the beta and
the market risk premium in the CAPM. Thus the CAPM fails if the market index is not
exactly the optimal mean-variance efficient as stated in proposition 5.
VI. Is the Market Index a Proper Explanatory Variable?
Since the CAPM is a tautology as proven in equation (6), there is no rationale for
exploring the testability of the model. Hence, any debate about the testability of the
CAPM should end. In empirical studies, the proxy of the market portfolio, which does
not depend on the mean and the covariance between the securities rate of return, has
been used as a substitute for the mean-variance market portfolio in the CAPM. Although
the weights of the market index are fixed and that index is not the mean-variance efficient
portfolio almost surely in probability
14
, the rate of return on the market index is used as
the explanatory variable to explain the rate of return on the security (or the mutual funds)
in the empirical studies. Is the market index a proper explanatory variable? This section
addresses the validity of the market index model, which has been used as the basic model
by previous empirical studies. In the regression model, the rate of the return on the
market index may still be a valid explanatory variable if the return on the market index is
not a function of the dependent variable of the rate of return on the risky asset. The
following single market index model has been used in the empirical studies in finance.
The single market index model is present as
25
t i t m i i t i
r R r R
, , ,
~
)
~
(
~
+ +
, (7)
where the t i
R
,
~
is the security rate of return at time t, t m
R
,
~
is the market index rate of
return at time t, t i,
~
m
2
, while the unsystematic (or firm-specific) risk is the variance of
the i
~
.
The estimated alpha
i
in equation (7) has been used to measure the risk-adjusted
abnormal rate of return in the empirical studies under the condition that the CAPM is
valid. If CAPM is a valid model, the expectation of the estimated alpha
i
for i-th asset in
equation (7) should be zero. If the estimated alpha is significantly different from zero,
one can conclude the existence of the anomalies and/or the market is inefficient.
However, as shown in Proposition 5 and in the numerical example in the last section,
since the market index is not exactly the mean variance efficient market portfolio almost
surely, the CAPM is invalid when using the market index. The invalidity of the CAPM
could cause significant non-zero alpha findings. Thus, the conclusions of anomalies
26
and/or market inefficiency based upon the significant non-zero estimated alpha could be
misleading and doubtful.
In reality, the market index is composed of a finite number of individual securities
in the market. These securities returns must be given before the market index return can
be calculated and determined in practice. As a result, the return on the market index is
affected by the return on these securities and not vice versa. However, equation (7) shows
that the rate of return on the market index affects the rate of return on the individual
security. This is not consistent with the real world and the assumption of causality
between the excess return on a security and the return on the market index underlying the
market model.
Furthermore, if the rate of return t i
R
,
~
on i-th security is also a component of the
market index return t m
R
,
~
, then the t i
R
,
~
is not just the dependent variable but also one
of components of the market index; the explanatory variable. This implies that regression
model of equation (7) is a misspecification model. If this kind of misspecification model
can be accepted, then why would another index like the return on the industry index not
be used to substitute for the return on the market index? After all, the industrial index
would be better than the market index for predicting or describing the rate of return on
the security because it is more highly correlated to its own industry index return than the
return on the market index in the real world. Taken to the extreme, though it is
meaningless, the individual security rate of return (i.e., the tautology model) is a perfect
explanatory variable to describe its own rate of return.
27
In particular, if equation (7) is used as the basic model to measure the
performance of mutual funds in empirical studies, the misspecification of equation (7)
could be more significant because more components in the mutual funds could be the
components of the market index as well.
Another problem for equation (7) is that the error term t i,
~
which is the
systematic risk for asset i, is not independent of the explanatory variable of the return on
market index t m
R
,
~
if t i
R
,
~
is one of the components of the market index. The non-zero
correlation between the error term and the explanatory variable violates of the
independence assumption between the explanatory variable and the error term in the
regression model. In addition, multiplying the weight used to compute the market index
to both sides of equation (7) and then summation over all assets in the index results to
0 +
i i t , i i
~
for all time t. A stochastic term plus a non-stochastic being zero
implies that
i i = 0 = t , i i
~
. That is, the error term of ith asset is not
independent to other assets error term for all time t. This could be another statistical
problem in the market index model for empirical financial studies.
VII. Conclusion
This paper uses an algebraic result to conclusively prove that the CAPM is dead
because it is a tautology. Given the expected excess return vector, no matter whether it is
at equilibrium or not, the non-singular covariance matrix implies that there must exist one
and only one portfolio, such that the expected excess rate of return on assets can be
28
rewritten as the product of its beta and the market risk premium as presented in equation
(6). Since, equation (1) is the necessary and sufficient condition for optimal portfolio
decision within the mean-variance framework and the CAPM exactly satisfies this
relationship, this leads to the mathematical conclusion that the market portfolio in the
CAPM must be the optimal mean-variance efficient portfolio and must depend on the
expected excess return. The mean-variance efficient market portfolio is a necessary and
sufficient condition for the CAPM, which is a mathematical tautology rather than an asset
pricing model. A tautology model of the CAPM is useless and doom for predicting the
rate of return on an asset in the real world. This paper also proves that the beta in the
CAPM depends on the expected excess return not vice versa. The greater expected rate of
return results in a greater beta which is in stark contrast with the perception that the
expected excess return is a linear function of the beta as stated in the CAPM. In statistics,
the expected excess rate of return on a security is a constant and should only depend on
its density function rather than other variables. Therefore, a constant of the expected
return on a security depends on beta in the CAPM is not justified and cannot be supported
by mathematics.
29
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4 425-442
32
1
As stated by Fama and French (1993,2004), the market portfolio can include not just the traded
financial assets, but also consumer durables, real estate, human capital, and non-traded assets.
2
Under the assumption that the CAPM is valid, Miller and Scholes (1972) analyze the statistical
problems inherent in previous empirical tests of the CAPM such as the misspecification of the
equation, the presence of the heteroscedasticity, and other problems.
3
For example, the size effect is explored by Banz (1981), Keim (1983), Roll (1981), Reinganum
(1982). Chan and Chen (1991), Chan et. al (1985), and others. The factors of the market to book value
and earnings/price ration on the excess return are examined by Fama and French (1992, 1993, 1996,
2004), Chan et. al (1991), and Bansal et. al (2005). The zero beta is studied by Shanken (1985), Roll
(1985)
4
The bold face represents vector or matrix in this paper. The ith element of R-r is R
i
-r; the expected
rate of return on the asset i minus risk-free rate r..
5
How to estimate the expected excess rate of return R-r and the elements of is not the object of this
paper.
6
See Theorem1, pp. 15 by Satake Ichiro (1975)
7
See Equation (7), pp. 596 by Lintner (1965), or Equation 6.1(or 13.1), pp.102 (or pp. 291) by Elton
et. al (2010). More precisely, equation (1) is the necessary and sufficient condition for maximizing the
Sharpe ratio.
8
=
-1
(R-r) =
m
or = c = c
m
m
=
m
implies ce
T
= c
m
e
T
m
, or c=c
m
. Therefore c(-
m
) = 0 or,
=
m.
9
Roll (1977) also reach to an if and only if relationship between return/beta and the market portfolio
mean-variance efficiency. The orthogonal portfolio z to the market portfolio in Rolls paper plays the
same role of risk-free in this paper (detailed see Corollary 6, pp 165).
10
Based upon their survey, Pablo and Javier (2010) report that the average market risk premium used
in 2010 by professors in the USA is 6.0%.
11
The Arbitrage Pricing Theory (APT) developed by Ross (1976) assumes the rate of return on a
security is generated by multiple common factors, whereas the expected rate of return and the
covariance in the CAPM are assumed being given at the beginning of the model setting.
12
The non-singular matrix is a one-to-one and onto isomorphic mapping, different portfolios will be
mapped onto different expected excess rate of returns by .
13
Without loss of generosity, all percentages in the rate of returns 5% and 10% and the standard
deviations 20% and 30% are all omitted. In this example, the correlation coefficient in this example is
assumed being 0.5. Both of the expected excess rate of return and covariance are assumed being given
by Sharpe, Lintner, and Mossin in their derivation of the CAPM.
14
Detailed see equation (3-10) pp. 64 by Greene (1997)