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Electronic copy available at: Copyright © Roger Dayala The Capital Asset Pricing Model, A Fundamental Critique Roger Dayala 2012 Accepted Paper Series Keywords: CAPM, Risk & Return, Modern Portfolio Theory, Roll’s Critique JEL Classifications: G10, G12, G15 Contact information: [email protected]
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Electronic copy available at: Copyright © Roger Dayala The Capital Asset Pricing Model, A Fundamental Critique Abstract The CAPM derives an ex post equilibrium relationship for the price of non-diversifiable risk based on investors utilizing two criteria only when making investment decisions: expected value and standard deviation. This article investigates the ex ante and ex post state of the CAPM in a hypothetical three-asset universe: either the CAPM irrationally indicates identical respective discount rates for different amounts of risks (i.e., total risk versus non-diversifiable risk) or the CAPM circularly indicates the ex ante price of total risk (read: standard deviation) depending on the ex post price of non-diversifiable risk. The CAPM is incomplete, if not fundamentally flawed.
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Copyright © Roger Dayala The Capital Asset Pricing Model (Sharpe (1964), and Lintner (1965)) (CAPM) is probably the most tested and discussed model in finance theory. Such has resulted in a vast amount of empirical evidence and (critical) reviews. Arguably though, within its own exact assumption set only one fundamental critique of the CAPM exists: Roll’s critique (1977). This paper aims to complement Roll in that regard: through employing a theoretical scenario in a one-period model of an ex ante and an ex post state in a three asset universe 1 it will be demonstrated the CAPM either suggests an irrational conclusion of rational risk averse investors attributing identical discount rates to different amounts of risk or a circular conclusion of the ex post fair price of non-diversifiable risk affecting the ex ante price of total risk. It is among the basic assumptions of the CAPM that investors utilize two parameters only for their decision making process, expected value and standard deviation (Sharpe, 1964: 428). Hence, the aforementioned ex ante state here describes the ex ante price of total risk (read: standard deviation) before the ‘revision of prices’ (Sharpe 1964: 435) as a consequence of the CAPM. The ex post state is after such revision of prices has already occurred as a result of investors pricing non-diversifiable risk only. The theoretical scenario will be analyzed from two angles. First we take a presumed equilibrium relationship as the ex ante price of total risk before employing the CAPM to calculate the ex post effects suggested by the CAPM on the pricing of non-diversifiable risk only. Next we take a presumed ex post equilibrium relationship for the fair price of non-diversifiable risk to deduct what the ex ante fair price of total risk could be.
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