A New Perspective on the Validity of the CAPM: Still Alive and Well

Abstract

The Capital Asset Pricing Model (CAPM) has far-reaching practical implications for both investors and corporate managers. The model implies that the market portfolio is mean variance efficient, and thus advocates passive investment. It also provides the most widely used measure of risk, beta, which is used to calculate the cost of capital and excess return (alpha). Most academic studies empirically reject the CAPM, leaving the lack of a better alternative as the only uneasy justification for using the model. Here we take a reverse-engineering approach for testing the model and show that with slight variations in the empirically estimated parameters, well within their estimation-error bounds, the CAPM perfectly holds. Thus, in contrast to the widely held belief, the CAPM cannot be empirically rejected.

Keywords: Mean variance efficiency, CAPM, portfolio optimization, beta

JEL Classification: G00