TOPIC 5

THE CAPITAL ASSET PRICING MODEL

NGUYEN THI HOANG ANH, PHD

Introduction
• Asset Pricing – how assets are priced?
• Market Equilibrium concept
• Portfolio Theory – ANY individual investor’s
optimal selection of portfolio (partial
equilibrium)
• CAPM – equilibrium of ALL individual
investors (and asset suppliers)
(general equilibrium)

1
Intuition
• Risky asset i:
• Its price is such that:

E(Returni) = Risk-free rate of return + Risk premium

specific to Asset i

= Rf + (Market price of risk) x (quantity of risk

of asset i)

CAPM tells us 1) The market price of risk

2) The risk of Asset i?

An example to motivate
Expected Return Standard Deviation
Asset I 10.9% 4.45%
Asset j 5.4% 7.25%

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)

Question: According to the above equation, given that asset j has

higher risk relative to asset i, why wouldn’t asset j has higher
expected return as well?

2
An example to motivate
Expected Return Standard Deviation
Asset I 10.9% 4.45%
Asset j 5.4% 7.25%

Possible Answers:
(1) The equation, as intuitive as it is, is wrong.
(2) The equation is right, but the market prices of risk are
different for different assets.
(3) The equation is right, but the quantity of risk of any risky
asset is not equal to the standard deviation of its return.

Answers from CAPM

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)

• The intuitive equation is right.

• The market price of risk in equilibrium should
be the same across ALL marketable assets
• In the equation, the quantity of risk of any
asset, however, is only PART of the total risk
(s.d) of the asset.

3
CAPM’s Answers
• Specifically:
Total risk = systematic risk + unsystematic risk

CAPM says:
(1) Unsystematic risk can be costlessly diversified
away. “No free lunch” implies the market will NOT
reward you for bearing unsystematic risk if there is
NO cost of eliminating it through well
diversification.
(2) Systematic risk cannot be diversified away without
cost. In other words, investors need to be
compensated by a certain risk premium for bearing
systematic risk.

MPT and the CAPM

• The Capital Asset Pricing Model builds
directly on Modern Portfolio Theory.

• It was developed in the mid-1960s by William

Sharpe (US, b.1934, Nobel Prize 1990), John
Lintner (US, 1916-1983), and Jan Mossin (Norway,
1936-1987).

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MPT and the CAPM
• William Sharpe, “Capital Asset Prices: A Theory of
Market Equilibrium Under Conditions of Risk,” Journal
of Finance Vol.19 (September 1964): pp.425-442.
• John Lintner, “The Valuation of Risk Assets and the
Selection of Risky Investments in Stock Portfolios and
Capital Budgets,” Review of Economics and Statistics
Vol.47 (February 1965): pp.13-37.
• Jan Mossin, “Equilibrium in a Capital Asset Market,”
Econometrica Vol.34 (October 1966): pp.768-783.

MPT and the CAPM

• But whereas Modern Portfolio Theory is a
theory describing the demand for financial assets,
the Capital Asset Pricing Model is a theory
describing equilibrium in financial markets.

• By making an additional assumption – namely,

that supply equals demand in financial markets – the
CAPM yields additional implications about the
pricing of financial assets and risky cash flows.

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MPT and the CAPM
• Like MPT, the CAPM assumes that investors have mean-
variance utility and hence that either investors have quadratic
utility functions or that the random returns on risky assets are
normallydistributed.
• Thus, some of the same caveats that apply to MPT also apply
to the CAPM.
• The traditional CAPM also assumes that there is a risk free
asset as well as a potentially large collection of risky assets.
• Under these circumstances, as we’ve seen, all investors will
hold some combination of the riskless asset and the tangency
portfolio: the efficient portfolio of risky assets with the highest
Sharpe ratio.

MPT and the CAPM

• But the CAPM goes further than the MPT by
imposing an equilibrium condition.
• Because there is no demand for risky financial assets except
to the extent that they comprise the tangency portfolio, and
because, in equilibrium, the supply of financial assets must
equal demand, the market portfolio consisting of all existing
financial assets must coincide with the tangency portfolio.
• In equilibrium, that is, “everyone” must “own the
market.”

6
MPT and the CAPM
• In equilibrium, that is, “everyone” must “own the
market.”
• But why? What happens if not enough people
want to “own the market.”
• Asset prices must adjust so that “everyone owns the
market.”
• This logic turns the MPT – a theory of asset
demand – into the CAPM – an asset pricing
model.

CAPM
• 2 Sets of Assumptions:
[1] Perfect market:
• Frictionless, and Perfect information
• No imperfections like tax, regulations, restrictions on
short selling
• All assets are publicly traded and perfectly divisible
• Perfect competition – everyone is a price-taker
[2] Investors:
• Same one-period horizon
• Rational, and maximize expected utility over a mean-
variance space
• Homogenous beliefs

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CAPM in Details:
What is an equilibrium?
CONDITION 1: Consistent with Individual investor’s Eqm.: Max U
• Assume:
[1] Market is frictionless
=> borrowing rate = lending rate
=> linear efficient set in the return-risk space
[2] Anyone can borrow or lend unlimited amount at risk-free rate
• [3] All investors have homogenous beliefs
=> they perceive identical distribution of expected returns on
ALL assets
=> thus, they all perceive the SAME linear efficient set (we
called the line: CAPITAL MARKET LINE
=> the tangency point is the MARKET PORTFOLIO
NOTE: 2-Fund Separation must hold under the above assumptions.

CAPM in Details:
What is an equilibrium?
CONDITION 1: Individual investor’s equilibrium: Max U

E(Rp) Capital Market Line

B
Q
E(RM)
Market Portfolio

Rf

σM
σp

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CAPM in Details:
What is an equilibrium?
CONDITION 2: Demand = Supply for ALL risky assets
• Remember expected return is a function of price.
• Market price of any asset is such that its expected return is just
enough to compensate its investors to rationally hold its
outstanding shares.

CONDITION 3: Equilibrium weight of any risky assets

• The Market portfolio consists of all risky assets.
• Market value of any asset i: 𝑉𝑖 𝑃𝑖 𝑄𝑖
• Market portfolio has a value of ∑iVi
• Market portfolio has N risky assets, each with a weight of wi
Such that
wi = Vi / ∑iVi for all i

CAPM in Details:
What is an equilibrium?
CONDITION 4: Aggregate borrowing = Aggregate
lending
• Risk-free rate is not exogenously given, but is
determined by equating aggregate borrowing and
aggregate lending.

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CAPM in Details:
What is an equilibrium?
Two-Fund Separation:
Given the assumptions of frictionless market, unlimited
lending and borrowing, homogenous beliefs, and if the above
4 equilibrium conditions are satisfied, we then have the 2-fund
separation.

TWO-FUND SEPARATION:
Each investor will have a utility-maximizing portfolio that is a
combination of the risk-free asset and a portfolio (or fund) of
risky assets that is determined by the Capital market line
tangent to the investor’s efficient set of risky assets
Analogy of Two-fund separation
Fisher Separation Theorem in a world of certainty. Related the
two separation theorems to help your understanding.

The Role of Capital Market

U’’ U’
E(rp)

Efficient set
P

Endowment Point

σp

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The Role of Capital Market

E(rp) U’’’ U’’ U’ Capital Market Line

U-Max Point

Efficient set
P

M
Endowment Point

Rf

σp

Deriving the CAPM

In the CAPM, equilibrium in financial markets requires the

demand for risky assets – the tangency portfolio – to coincide
with the supply of financial assets – the market portfolio.

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Deriving the CAPM

The CAPM’s first implication is immediate: the market

portfolio is efficient (lies on the efficient frontier).

Deriving the CAPM

The line originating at (0, rf ) and running through (σM, E (r˜M))

is called the capital market line(CML).

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Deriving the CAPM

Hence, it also follows that all individually optimal portfolios

are located along the CML and are formed as combinations of
the risk free asset and the market portfolio.

Deriving the CAPM

• Recall that the trade-off between the standard deviation and
expected return of any portfolio combining the riskless asset
and the tangency portfolio is described by the linear
relationship
E  rT   rf
E  rP   rf  P
T
Since the CAPM implies that the tangency and market
portfolios coincide, the formula for the Capital Market
Line is likewise
E  rM   rf
E  rP   rf  P
M

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Deriving the CAPM
And since all individually optimal portfolios are located
along the CML, the equation
E  rM   rf
E  rP   rf  P
M
implies that the market portfolio’s Sharpe ratio
E  rM   rf
M
measures the equilibrium price of risk: the expected return
that each investor gives up when he or she adjusts his or her
total portfolio to reduce risk.

Deriving the CAPM

Next, let’s consider an arbitrary asset – “asset j ” – with
random return 𝑟˜𝑗 expected return 𝐸 𝑟˜𝑗 , and standard
deviation 𝜎𝑗 .

MPT would take 𝐸 𝑟˜𝑗 and 𝜎𝑗 as “data” – that is, as given.

The CAPM again goes further and asks: if asset j is to be

demanded by investors with mean-variance utility, what
restrictions must E 𝑟˜𝑗 and 𝜎𝑗 satisfy?

14
Deriving the CAPM
• To answer this question, consider an investor who takes the
portion of his or her initial wealth that he or she allocates to
risky assets and divides it further: using the fraction w to
purchase asset j and the remaining fraction 1 𝑤 to buy
the market portfolio.

• Note that since the market portfolio already includes some

of asset j , choosing w > 0 really means that the investor
“overweights” asset j in his or her own portfolio. Conversely,
choosing w < 0 means that the investor “underweights” asset
j in his or her own portfolio.

Deriving the CAPM

• Based on our previous analysis, we know that this
investor’s portfolio of risky assets now has random return
𝑟˜𝑃 𝑤𝑟˜𝑗 1 𝑤 𝑟˜𝑀,

expected return
𝐸 𝑟˜𝑃 𝑤𝐸 𝑟˜𝑗 1 𝑤 𝐸 𝑟˜𝑀 ,

and variance

𝜎 𝑤 𝜎 1 𝑤 𝜎 2𝑤 1 𝑤𝜎

where 𝜎𝑗𝑀 is the covariance between r˜𝑗 andr˜𝑀.

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Deriving the CAPM
𝐸 𝑟˜𝑃 𝑤𝐸 𝑟˜𝑗 1 𝑤 𝐸 𝑟˜𝑀 ,

𝜎 𝑤 𝜎 1 𝑤 𝜎 2𝑤 1 𝑤𝜎

• We can use these formulas to trace out how σP and

𝐸 𝑟˜𝑃 vary as w changes.

Deriving the CAPM

The red curve these traces out how σP and E (r˜P) vary as w
changes, that is, as asset j gets underweighted or
overweighted relative to the market portfolio.

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Deriving the CAPM

The red curve passes through M, since when w = 0 the new

portfolio coincides with the market portfolio.

Deriving the CAPM

For all other values of w , however, the red curve must lie
below the CML.

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Deriving the CAPM

Otherwise, a portfolio along the CML would be dominated in

mean-variance by the new portfolio. Financial markets would
no longer be in equilibrium, since some investors would no
longer be willing to hold the market portfolio.

Deriving the CAPM

Suppose that at W , w > 0. Then asset j is “undervalued” in

the sense that overweighting it will yield a portfolio with a
higher expected return.

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Deriving the CAPM
• But as all investors buy this undervalued asset,
its price will rise.
• Given future cash flows (future price from selling
the asset plus any dividends earned), a rise the asset’s
price will lower its expected return.
• Buying pressure will continue until the red curve
bends back below the CML.

Deriving the CAPM

Suppose that at W , w < 0. Then asset j is “overvalued” in

the sense that underweighting it will yield a portfolio with a
higher expected return.

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Deriving the CAPM
• But as all investors sell this overvalued asset, its
price will fall.

• Given future cash flows, a fall the asset’s price

will raise its expected return.

• Selling pressure will continue until the red curve

bends back below the CML.

Deriving the CAPM

Together, these observations imply that the red curve must be

tangent to the CML at M.

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Deriving the CAPM

Tangent means equal in slope.

We already know that the slope of the Capital Market Line is

E  rM   rf
M

But what is the slope of the red curve?

Deriving the CAPM

Let f (σP ) be the function defined by E (r˜P) = f (σP ) and

therefore describing the red curve.

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Deriving the CAPM
Next, define the functions g (w ) and h(w )by

𝑔 𝑤 𝑤𝐸 𝑟˜𝑗 1 𝑤 𝐸 𝑟˜𝑀 ,

/
h(w)=) 𝑤 𝜎 1 𝑤 𝜎 2𝑤 1 𝑤𝜎

so that
𝐸 𝑟˜𝑃 𝑔𝑤
and
𝜎𝑃 ℎ𝑤 .

Deriving the CAPM

Substitute
𝐸 𝑟˜𝑃 𝑔𝑤
and
𝜎𝑃 ℎ𝑤 .
into
𝐸 𝑟˜𝑃 𝑓 𝜎𝑃
to obtain
𝑔𝑤 𝑓 ℎ𝑤
and use the chain rule to compute

𝑔′ 𝑤 𝑓′ ℎ 𝑤 ℎ′ 𝑤 𝑓 ′ 𝜎𝑃 ℎ′ 𝑤

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Deriving the CAPM

Let f (σP ) be the function defined by 𝐸 𝑟˜𝑃 𝑓 𝜎𝑃 and

therefore describing the red curve. Then 𝑓 ′ 𝜎𝑃 is the slope of
the curve.

Deriving the CAPM

Hence, to compute 𝑓 ′ 𝜎𝑃 , we can rearrange

𝑔′ 𝑤 𝑓 ′ 𝜎𝑃 ℎ′ 𝑤
𝑔′ 𝑤
to obtain 𝑓′ 𝜎
ℎ′ 𝑤
and compute 𝑔 ′ 𝑤 and ℎ′ 𝑤 from the formulas we
know.

23
Deriving the CAPM

𝑔𝑤 𝑤𝐸 𝑟˜𝑗 1 𝑤 𝐸 𝑟˜𝑀 ,
implies
𝑔′ 𝑤 𝐸 𝑟˜𝑗 𝐸 𝑟˜𝑀

Deriving the CAPM

/
h(w)=) 𝑤 𝜎 1 𝑤 𝜎 2𝑤 1 𝑤𝜎

implies
 
1  2 w j  2 1  w   M  2(1  2 w) jM 
2 2

h '  w   
2   w2 2  1  w 2  2  2 w(1  w) 1/2 
 j M jM  

or, a bit more simply,

w 2j  1  w   M2  (1  2 w) jM
h '  w  1/ 2
 w2 2j  1  w 2  M2  2 w(1  w) jM 
 

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Deriving the CAPM

g '  w
f '  P  
h '  w

𝑔′ 𝑤 𝐸 𝑟˜𝑗 𝐸 𝑟˜𝑀

w 2j  1  w   M2  (1  2 w) jM
h '  w  1/ 2
 w2 2j  1  w 2  M2  2 w(1  w) jM 
 

1/2
 w2 2j  1  w 2  M2  2 w(1  w) jM 
f '  P    E (rj )  E (rM )    
w j  1  w   M  (1  2 w) jM
2 2

Deriving the CAPM

The red curve is tangent to the CML at M. Hence, 𝑓′ 𝜎𝑃 )

equals the slope of the CML when w=0.

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Deriving the CAPM
When w = 0,
1/2
 w2 2j  1  w 2  M2  2 w(1  w) jM 
f '  P    E (rj )  E (rM )    
w j  1  w   M  (1  2 w) jM
2 2

implies
M
f '  P    E (rj )  E (rM )  
 jM   M2

Meanwhile, we know that the slope of the CML is

E (rM )  rf
M

Deriving the CAPM

The tangency of the red curve with the CML at M therefore

requires
M E ( rM )  rf
 E ( rj )  E (rM )   
  2 jM M M

 E (r
M )  rf   jM   M2 
 E (rj )  E (rM )  
 M2
 
2 
 E (rj )  E (rM )    jM E (rM )  rf    E ( rM )  rf 
 M 

  jM 
E (rj )  rf   2   E (rM )  rf 
 M 

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Deriving the CAPM

  jM 
E (rj )  rf   2   E (rM )  rf 
 M 
Let   jM 
  2 
 M 
so that this key equation of the CAPM can be written as

E ( rj )  rf   j  E (rM )  rf 

where βj , the “beta” for asset j , depends on the covariance

between the returns on asset j and the market portfolio.

Deriving the CAPM

E (rj )  rf   j  E (rM )  rf 
This equation summarizes a very strong restriction.

It implies that if we rank individual stocks or portfolios of

stocks according to their betas, their expected returns should
all lie along a single security market line with slope 𝐸 𝑟˜𝑀 𝑟𝑓 .

27
Deriving the CAPM

According to the CAPM, all assets and portfolios of assets lie

along a single security market line. Those with higher betas
have higher expected returns.

Deriving the CAPM

• There are several complementary ways of
interpreting this result.
• All bring us back to the theme of diversification
emphasized by MPT.
• But all take us a step further, by emphasizing as
well the distinction between idiosyncratic risk,
which can be “diversified away,” and aggregate risk,
which cannot be diversified away.

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Interpreting the CAPM
• The first interpretation goes directly back to the MPT: a
stock with low and especially negative σjM will be most
useful for diversification.
• But then all investors will want to hold that stock. In
equilibrium, therefore, the stock’s price will be high and,
given future cash flows, its expected return will be low.
• Therefore, stocks with low or negative betas will have low
expected returns. Investors hold these stocks, despite their low
expected returns, because of they are useful for diversification.

Interpreting the CAPM

• Conversely, a stock with high, positive σjM will not be very
useful for diversification.

• In equilibrium, therefore, the stock will sell for a low price.

• Therefore, stocks with high betas will have high expected

returns. The high expected return is needed to compensate
investors, because the stock is not very useful for
diversification.

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Interpreting the CAPM
The second interpretation uses the CAPM equation
in its original form
  jM 
E ( rj )  rf   2   E ( rM )  rf 
 M 
together with the definition of correlation, which implies
 jM
 jM 
 j M

to re-express the CAPM relationship as

  E (rM )  rf   
E (rj )  rf   j
 M  jM
 

Interpreting the CAPM

  E (rM )  rf   
E (rj )  rf   j
 M  jM
 

The term inside brackets is the equilibrium price of risk.

And since the correlation lies between −1 and 1, the term

ρjMσj , satisfying
ρjMσj ≤ σj,
represents the “portion” of the total risk σj in asset j that is
correlated with the market return.

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Interpreting the CAPM

  E (rM )  rf   
E (rj )  rf   j
 M  jM
 

The idiosyncratic risk in asset j , that is, the portion that is

uncorrelated with the market return, can be diversified away by
holding the market portfolio.

Since this risk can be freely shed through diversification, it is

not “priced.”

Interpreting the CAPM

  E (rM )  rf   
E (rj )  rf   j
 M  jM
 

Hence, according to the CAPM, risk in asset j is priced only to

the extent that it takes the form of aggregate risk that,
because it is correlated with the market portfolio, cannot be
diversified away.

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Interpreting the CAPM

  E (rM )  rf   
E (rj )  rf   j
 M  jM
 

Thus, according to the CAPM:

1. Only assets with random returns that are positively
correlated with the market return earn expected returns
above the risk free rate. They must, in order to induce
investors to take on more aggregate risk.

Interpreting the CAPM

  E (rM )  rf   
E (rj )  rf   j
 M  jM
 

Thus, according to the CAPM:

2. Assets with returns that are uncorrelated with the market
return have expected returns equal to the risk free rate,
since their risk can be completely diversified away.

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Interpreting the CAPM

  E (rM )  rf   
E (rj )  rf   j
 M  jM
 

Thus, according to the CAPM:

3. Assets with negative betas – that is, with random returns
that are negatively correlated with the market return –
have expected returns below the risk free rate! For these
assets, 𝐸 𝑟˜𝑗 𝑟𝑓 0 is like an “insurance premium”
that investors will pay in order to insulate themselves from
aggregate risk.

Interpreting the CAPM

The third interpretation is based on a statistical regression of
the random return rj̃ on asset j on a constant and the market
return r˜M
rj     rM   j
This regression breaks the variance of rj̃ own into two
“orthogonal” (uncorrelated) components:
1. The component βj r˜M that is systematically related to
variation in the market return.
2. The component εj that is not.
Do you remember the formula for βj , the slope coefficient in a
linear regression?

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Interpreting the CAPM

Consider a statistical regression of the random return r˜jon

asset j on a constant and the market return r˜M:

rj     rM   j
Do you remember the formula for βj , the slope coefficient in a
linear regression? It is
σjM
βj = 2
σM

the same “beta” as in the CAPM!

Interpreting the CAPM

Consider a statistical regression:

 iM
rj     rM   j with  
 M2
the same “beta” as in theCAPM!

But this is not an accident: to the contrary, it restates the

conclusion that, according to the CAPM, risk in an individual
asset is priced – and thereby reflected in a higher expected
return – only to the extent that it is correlated with the
market return.

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Interpreting the CAPM

Note that high beta stocks tend to be in industries that are

highly cyclical. These stocks must offer higher expected
returns, to get investors to accept the risk.

Stocks with lower betas tend to be in industries less affected

by macroeconomic conditions. Investors pay for this stability
by accepting lower expected returns.

Use”s” of CAPM
• For valuation of risky assets

• For estimating required rate of return of risky projects

• As you can see from stocks quotations, beta is a

prominent measure everywhere. The usage of CAPM
is wide-spreaded. Think of other uses of CAPM as an
exercise for yourself. Do some research on it to help
yourself understand more.

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How to test CAPM
• An enormous literature is devoted to empirically testing the
CAPM’s implications.
• Although results are mixed, studies have shown that when
individual portfolios are ranked according to their betas, expected
returns tend to line up as suggested by thetheory.
• A famous article that presents results along these lines is by
Eugene Fama (Nobel Prize 2013) and James MacBeth, “Risk,
Return, and Equilibrium,” Journal of Political Economy Vol.81
(May-June 1973), pp.607-636.
• Early work on the MPT, the CAPM, and econometric tests of
the efficient markets hypothesis and the CAPM is discussed
extensively in Eugene Fama’s 1976 textbook, Foundations of
Finance.

[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

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[2] Testable ?

E (rj )  rf   j  E (rM )  rf 
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 (rj )  rf   j  E (rM )  rf 
In reality, we make compromises:
[a] short-term T-bill (not entirely risk-free)
[b] Proxy of market-portfolio (not the true market)
{E(RM)}
[c] Historical beta
{βi = cov(Ri,RM)/var(RM)}

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[2] Testable ?
Problem 1:
What is the market portfolio? We never truly observe the
entire market.
We use stock market index to proxy market, but:
[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 capital?
[iii] Which market index to use? Or how many to use?
[iv] What about international market?

[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?

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[2] Testable ?
Problem 3:
Borrowing restrictions. Short-selling restrictions.

Problem 4:
Expected return measurement.
[i] are historical returns good proxies for future
expected returns? Ex Ante VS Ex Post

[3] Regression
E (rj )  rf   j  E (rM )  rf 
E (rj )  rf   j  E (rM )  rf 
With our compromises, we test :
E (rj )  rf   j  E (rM )  rf 
Using the following regression equation :

E (rj )  rf   0   1 j   j
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!!!

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[3] Regression

E (rj )  rf   0   1 j   j
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

E (rj )  rf   0   1 j   j
[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
return
(firm size, p/e ratio, dividend yield, seasonality)
[e] Linearity holds, β2 & unsystematic risk become
insignificant under the presence of β.

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[4] Generally agreed results

[Rit – Rft]
CAPM Predicts

Actual

γ1 = (RMt - Rft)
γ0 = 0 βi

Roll’s Critique
Message: We aren’t really testing CAPM.
Joint Hypothesis testing:
1) “CAPM is valid” and 2) “Market portfolio is ex post efficient”

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 ex post
efficient or not.

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Against CAPM
• More recent evidence against the CAPM’s implications
is presented by Eugene Fama and Kenneth French,
“Common Risk Factors in the Returns on Stocks and
Bonds,” Journal of Financial Economics Vol.33 (February
1993): pp.3-56.
• This paper shows that equity shares in small firms and in
firms with high book (accounting) to market value have
expected returns that differ strongly from what is predicted
by the CAPM alone.
• Quite a bit of recent research has been directed
towards understanding the source of these “anomalies.”

Final words
• Despite some empirical shortcomings,
however, the CAPM quite usefully deepens
our understanding of the gains from
diversification.
• Related, the CAPM alerts us to the important
distinction between idiosyncratic risk, which
can be diversified away, and aggregate risk,
which cannot

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Final words
• Like MPT, the CAPM must rely on one of the two
strongassumptions – either quadratic utility or
normally-distributedreturns – that justify mean-
variance utility.
• And while the CAPM is an equilibrium theory of
asset pricing, it stops short of linking asset returns to
underlying economic fundamentals.
• These last two points motivate our interest in other
asset pricing theories, which are less restrictive in
their assumptions and/or draw closer connections
between asset prices and the economy as a whole.

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