On the validity of the Capital Asset Pricing Model

Abstract

One of the most important developments of modern finance is the Capital Asset Pricing Model (CAPM) of Sharpe, Lintner and Mossin. Although the model has been the subject of several academic papers, it is still exposed to theoretical and empirical criticisms. The CAPM is based on Markowitz’s (1959) mean variance analysis. Markowitz demonstrated that rational investors would hold assets, which offer the highest possible return for a given level of risk, or conversely assets with the minimum level of risk for a specific level of return. Building on Markowitz’s work, Sharpe and Lintner after making a number of assumptions, developed an equilibrium model of exchange showing the return of each asset as a function of the return on the market portfolio. This model and its underlying assumptions are reviewed in section 1. This model known as the Capital Asset Pricing Model has since been the focus of a number of empirical tests, and as shown in sections 3 and 5 the majority of these tests deny the validity of the model. However, as discussed in sections 4 and 6 these tests have not been free of criticism. Section 2 briefly presents a framework under which the empirical tests of the CAPM can be carried out. Section 7 provides a conclusion.