Abstract

The capital asset pricing model (CAPM) of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a Nobel Prize for Sharpe in 1990). Before their breakthrough, there were no asset pricing models built from first principles about the nature of tastes and investment opportunities and with clear testable predictions about risk and return. Four decades later, the CAPM is still widely used in applications, such as estimating the cost of equity capital for firms and evaluating the performance of managed portfolios. And it is the centerpiece, indeed often the only asset pricing model taught in MBA level investment courses. The attraction of the CAPM is its powerfully simple logic and intuitively pleasing predictions about how to measure risk and about the relation between expected return and risk. Unfortunately, perhaps because of its simplicity, the empirical record of the model is poor–poor enough to invalidate the way it is used in applications. The model’s empirical problems may reflect true failings. (It is, after all, just a model.) But they may also be due to shortcomings of the empirical tests, most notably, poor proxies for the market portfolio of invested wealth, which plays a central role in the model’s predictions. We argue, however, that if the market proxy problem invalidates tests of the model, it also invalidates most applications, which typically borrow the market proxies used in empirical tests. For perspective on the CAPM’s predictions about risk and expected return, we begin with a brief summary of its logic. We then review the history of empirical work on the model and what it says about shortcomings of the CAPM that pose challenges to be explained by more complicated models.

Scientific Portfolio AI- Generated Summary

“The Capital Asset Pricing Model: Theory and Evidence” is a comprehensive review of the Capital Asset Pricing Model (CAPM), a widely used model in finance that attempts to explain the relationship between risk and expected return. The paper begins by discussing the origins of the CAPM and its assumptions, which include the existence of a risk-free asset, rational investors, and homogeneous expectations. The authors then delve into the model’s theoretical underpinnings, including the concept of systematic risk and the market portfolio.

The paper goes on to examine the empirical evidence for the CAPM, which has been mixed at best. While the model has been successful in explaining some aspects of asset pricing, such as the cross-sectional variation in expected returns, it has struggled to account for other phenomena, such as the size and value effects. The authors attribute these shortcomings to the simplifying assumptions made in the model, which do not reflect the complexities of real-world markets.

The authors then discuss some of the alternative asset pricing models that have been developed to address the shortcomings of the CAPM. These include the Fama-French three-factor model, which adds size and value factors to the CAPM, and the Carhart four-factor model, which adds a momentum factor. While these models have had some success in explaining asset pricing, they too have their limitations.

The paper concludes by discussing some of the implications of the CAPM and its alternatives for investors and asset managers. The authors note that while the CAPM may not be a perfect model, it is still widely used in practice, and investors should be aware of its limitations. They also note that the development of alternative models has led to a better understanding of asset pricing, and that investors should consider using multiple models in their investment decisions.

Overall, “The Capital Asset Pricing Model: Theory and Evidence” provides a thorough and insightful review of the CAPM and its alternatives. The paper is well-written and accessible, making it a valuable resource for anyone interested in asset pricing theory and practice.