Linear Beta Pricing with Inefficient Benchmarks
University of Piraeus - Department of Banking and Financial Management
University of New South Wales - Banking & Finance, Australian School of Business; Financial Research Network (FIRN)
March 11, 2013
Forthcoming, Quarterly Journal of Finance
20th Australasian Finance & Banking Conference 2007 Paper
UNSW Australian School of Business Research Paper No. 2011 BFIN 08
Current asset pricing models require mean-variance efficient benchmarks, which are generally unavailable because of partial securitization and free float restrictions. We provide a pricing model that uses inefficient benchmarks, a two-beta model, one induced by the benchmark and one adjusting for its inefficiency. While efficient benchmarks induce zero-beta portfolios of the same expected return, any inefficient benchmark induces infinitely many zero-beta portfolios at all expected returns. These make market risk premiums empirically unidentifiable and explain empirically found dead betas and negative market risk premiums. We characterize other misspecifications that arise when using inefficient benchmarks with models that require efficient ones. We provide a space geometry description and analysis of the specifications and misspecifications. We enhance Roll (1980), Roll and Ross’s (1994), and Kandel and Stambaugh’s (1995) results by offering a “Two Fund Theorem,” and by showing the existence of strict theoretical “zero relations” everywhere inside the portfolio frontier.
Number of Pages in PDF File: 44
Keywords: Linear beta pricing, CAPM, expected returns, incomplete information, zero relation
JEL Classification: G10, G12
Date posted: March 29, 2006 ; Last revised: April 17, 2013
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