Explanations for the Volatility Effect: An Overview Based on the CAPM Assumptions

Abstract

The Capital Asset Pricing Model (CAPM) predicts a positive relation between risk and return, but empirical studies find the actual relation to be flat, or even negative. This paper provides a broad overview of explanations for this ‘volatility effect’ that have been proposed in different streams of literature, and categorizes each explanation according to the CAPM assumption it relates to. Interestingly, various explanations relate to investor behavior that is rational given exogenous incentive structures or constraints, which may explain why the volatility effect has been so persistent over time. We argue that although the CAPM may be bad at explaining reality, addressing the reasons for its failure could actually be a normative arbitrage opportunity.

Keywords: volatility effect, anomaly, CAPM, arbitrage, asset pricing, agency effects, behavioral finance, low-beta anomaly

JEL Classification: F20, G11, G12, G14, G15