The Relative Asset Pricing Model: Incorporating Liabilities and Delegation to Chief Investment Officers — Version 0.1
16 Pages Posted: 8 May 2013
Date Written: March 1, 2013
This paper makes a simple but bold argument that because mean-variance optimization (MVO) and the capital asset pricing model (CAPM) were derived from a theoretical construct rather than reality, they represent a specialized case of a more general theory. We suggest a theory based on the liability to be serviced by an investment portfolio that is managed by a delegated decision maker. From this perspective, all decisions are relative; hence we present a relative asset pricing model (RAPM) as the true starting point for asset pricing theory. RAPM accommodates the fact that real investors are concerned about the relative return of their portfolios (relative mean) and the relative risk of their portfolios (composed of two independent variables — relative variance and correlation). Moreover, investors are concerned about their agents’ skill to generate alpha. Turning off these features gives us CAPM; hence our claim that CAPM is a stylized model of a more general theory. Because current theory was derived from the assumptions that investors are concerned about their absolute wealth and that they know the return distribution, which is characterized by mean and variance, it misses an important part of real-life decision making. When investors are concerned about the relative return of their portfolios and do not know the return distribution that is generated by their agents, correlation matters in addition to mean and variance. Therefore investment decision making will occur in three-dimensional space rather than the mean-variance two-dimensional plane. A decision maker forced to choose only two of three or more independent variables would get a limited result. This is exactly what happens with investment theory. This paper provides the foundation for adding a correlation dimension. We hope that other talented academics will help develop RAPM, which will provide better recommendations for asset pricing, asset allocation, rebalancing, risk-adjusted performance calculations, and manager compensation.
Keywords: relative asset pricing model, asset pricing theory
JEL Classification: G00, G10, G11
Suggested Citation: Suggested Citation