A more general model of risk and return is needed

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Unformatted text preview: 9 2.53 3.01 3.19 3.71 1.41 0.75 0.93 I.00 1.34 1.35 R(r) - RF(r) = u + ~[RM(I) - RF(r)] + ($0 0.42 0.3’) 0.39 0.35 0.20 0.54 0.53 0.50 0.57 0.21 - O.YO - 1.00 - 1.12 - 0.50 - 0.4Y — The market is inefficient —investors are truly not that smart— and we need a new model for market equilibrium. — A more general model of risk and return is needed, true. But we do not need to go as far as calling investors stupid. Multi-factor models are very popular nowadays. — Tests with historical data are really useless because covariances are supposed to be forward looking. I think this would make almost 50% of statistics useless so it’s a little bit strong for me. — (Roll’s critique) The market portfolio is unobservable, so we are not really testing the CAPM, but the quality of a proxy such as a stock index. Failure in these tests simply tells us that the proxy is bad, but nothing about the CAPM itself. 4 Is the CAPM used in practice? • Does the empirical failure invalidate the CAPM as a benchmark for capital budgeting? • Not necessarily. Why? — Good intuition. — It gives "reasonable" estimates of your opportunity cost....
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