The CAPM is Alive and Well

Haim Levy, EFM 2010

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Comments
1. Overall, I felt the paper was a good primer that confirms the role of
the CAPM as the lingua franca of finance, regardless of neoclassical
or behavioral schools. It is a much more robust model than the first
type suggested by Sharpe, Lintner, and Mossin.
2. Yet at the same time, despite the optimistic tone of the title of the
paper, the conclusion is somewhat less cheerful for future researchers.
After all, the major criticism in the finance world has been that the
researchers have had diculties in escaping from the CAPM paradigm.
To quote Due (1992):
To someone who came out of graduate school in the mideighties, the decade spanning roughly 196979 seems like a
golden age of dynamic asset pricing theory . . . The decade
or so since 1979 has, with relatively few exceptions, been a
mopping-up operation.
3. However, the paper does not help bridge the empirical gap of the
CAPM. The poor explanatory power of the CAPM in its most baseline
form means that the model has to be modified in one way or the other.
4. Moreover, the authors point that the CAPM holds on an ex ante basis
with experimental beta is far too naive.
5. Although the CAPM is robust to a wide range of alternative specifications (non-EUT preferences, Safety-First rule assumptions...) the
model no longer holds when all these alternative assumptions are held
at the same time.

Research Ideas
1. There are many variants of the CAPM - consumption CAPM, CAPM
with time-varying betas, human capital in the market portfolio etc.
Can a measure be constructed to give the winning hand to either of
these models?
2. Can the Fama-French 3-factor model be summarized into a single factor CAPM, under several assumptions?

Appendix: Summary of the Paper

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The Logic of the CAPM

The Main Criticisms of MV Analysis and the CAPM

2.1

Theoretical criticisms of EUT and CAPM

Allais Paradox Allais believes the idea of using decision weights instead of objective probabilities suits portfolio choices better.
Safety First Rule Roy (1952) believes safety first rule is more prevalent: making EUT generally invalid.
Risk-aversion A typical investor has both risk-seeking and risk-averting
elements.
PT K-T and T-K Prospect Theories suggest economic agents behave
in a fashion contradictory to EUT. The criticisms are wide-ranging,
not just about the shape of the preference mentioned above.
MV Baumol (1963) and Leshno and Levy (2002) point out MV is a
sucient yet not a necessary investment decision rule.

2.2

Empirical Criticisms of the MV and the CAPM

CAPM implies that dierences in expected return across portfolios
and securities should be entirely explained by dierences in market
beta.
Other variables should add nothing to the explanatory power of
the model.
Fama and Macbeth (1973) test using additional variables of squared
market betas and residual variances from regressions: finding that
these variables do not add to the explanation.
Alternatively we could test using time-series regressions, since one
could estimate the time series regression for a set of assets and then
jointly test the regression intercepts against zero.
In this spirit, Gibbons, Ross and Shanken (1989) provide an
F-test on the intercepts that has exact small-sample properties
(GRS test).
However, an important caveat is that these tests strictly speaking do
not test the CAPM but test whether a specific market portfolio proxy
is ecient in the set of portfolios (Rolls critique, Roll 1977).

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3.1

Overcoming the Theoretical Criticisms of the CAPM

The Allais Paradox
If Normal distributions are assumed and monotonic DAW are employed as in various behavioural models, all investors select portfolios
located on the CML.

3.2

Roys Safety First Rule

According to the extreme Safety First rule, one uses the following
objective function:
p = argmin Pr (x < d)

where d denotes disaster level, x stands for rate of return, p denotes

a vector of optimal investment opportunities.

We devote special attention to the case where d = r.
Assuming that the investor places > 0 portion of her wealth
in risky assets, and using Chebyshevs inequality the following
conditions hold:
1
P r(|x | > k) 2
k
P r(x < d) 2 /( d)2
Since investing in an interior portfolio will increase the probability of a disaster, all investors regardless of di will invest in MV
ecient portfolios ie zerobeta version of the CAPM.

3.3

Overcoming the risk-aversion assumption

3.4

Cumulative prospect theory

The Cumulative Prospect Theory (CPT) by Tversky and Kahneman
use the following value function:
{
x if x 0
V (x) =
(1)
(x ) if x < 0
where 0 < < 1. 0 < < 1, > 1.
The investors also use decision weights.
Because of focus on change of wealth and decision weights rather than
total wealth and probabilities, the transformed distribution may not
be normal even if the original distribution is normal.
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3.5

Overcoming Baumol, Leshno and Levy

MV rule may lead to a paradox according to Baumol (1963), and
assumptions of stochastic dominance should be revised with economic
considerations according to Leshno and Levy (2004).
Leshno and Levy propose an alternative measure of Almost Stochastic Dominance (ASD) and Almost-MV rules. For example, for
most investors, F ASD G even though does not F FOSD G if:
G N (, 2 ) = N (1, 1)
F N (, 2 ) = N (10, 2)
Baumol proposes the following investment rule instead of the MV
rule, under which, the market portfolio may located in the inecient segment of Baumols set.
EF (x) EG (x)
LF (x) = EF (x) kF LG (x) = EG (x) kG
For the market portfolio and the CML to be ecient, the following
condition must hold:
r
E
=
= constant < k

Mean annual return of the market portfolio is about 12% with a standard deviation of about 20%, riskless interest rate of about 4%: hence
the slope of the CML is less than 1. Yet Baumols k must be greater
than 1.0 so the derivative requirement must hold.
By contrast, unlike in the case of Baumol, for Leshno and Levy the
market portfolio may be inecient and an alternative portfolio m may
dominate it. Yet since m is a linear combination of m and the riskless
asset, all investors will end up holding a combination of m and the
riskless asset.

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4.1

Overcoming the Empirical Criticism of the CAPM

The normality assumption
Elliptical (notably distributions that are symmetric around ) distribution is crucial to the derivation of the CAPM.
Yet, numerous studies show that empirical distributions are skewed
and have fatter tails relative to the Normal distribution.
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 Notable studies include Mandelbrot (1963), Fama (1965), Ocer (1972), Clark (1973), Gray and French (1990), Zhow (1993),
Mantegna and Stnaley (1995), Focardi and Fabozzi (2003), and
Levy and Duchin (2004).
Levy and Duchin (2004) show that the logistic distribution gives the
best fit on a monthly basis, yet other (lognormal) distributions are
fitted best under longer horizons.
Kroll et al. and Markowitz show that all risk-averse utility functions can be approximated locally by a quadratic function (ie a
function whose expected value depends only on location and scale
parameter). The utility loss caused by approximation is shown
to be negligible.
Other studies directly measure the financial loss due to the Normality assumption when the empirical rates are not normally distributed.
4.2

The CAPM - empirical and experimental tests

Claim: Although CAPM is rejected with ex post parameters, it cannot
be rejected with ex ante parameters (namely beta).
Earlier tests of CAPM tests relied on two-stage regressions.
Virtually all empirical tests reveal that CAPM is rejected and the R2
is generally low (4% with monthly and 20% with annual data) at the
individual assets level.
4.2.1

Ex ante beta

The underlying assumption behind the two-stage test is that the

ex ante beta is correct.
Levy (1983) finds that when adjusted for ex ante betas, almost perfect second-pass regression is obtained.
Even with ex-post betas, various portfolios sorted by price
ratios suggest a positive beta-return relationship if the period
is extended.
4.2.2

Eciency of the market portfolio

Roll (1977) claims that the only relevant test is to determine if

the employed market portfolio is mean-variance ecient, all else
being technical.

 Levy and Roll (2008) however show that only minor adjustments
in mean and variance is needed to make the observed market
portfolio mean-variance portfolio.
4.2.3

Negative investment weigh

According to Roll (1977), negative weights on assets is evidence

against the validity of the CAPM.
However, Levy (2008a) constructs a test to examine if ex ante
betas can be positive yet ex post betas be negative.
Looking for positive portfolios in parameter space is somewhat like looking for rational numbers on the number line:
if a point in the parameter space is chosen at random it
almost surely corresponds to non-positive portfolio (an irrational number); however, one can find very close points in
parameter space corresponding to positive portfolios.
4.2.4

Experimental studies of the CAPM

Empirically it is not possible to test the CAPM with ex ante

parameters, but in experiments, YES.
In this experiment, agents are given a random variable R (with
distributions), and subjects are asked their willingness to pay.
Aggregating the data shows both demand, supply as well as market clearing prices.
Levy (1997) finds support for the CAPM with 70% explanatory power.
Bossaerts and Plott (2002)also find evidence that concurs.

Concluding remarks