The Relative Asset Pricing Model: Implications for Asset Allocation, Rebalancing and Asset Pricing

32 Pages Posted: 4 Dec 2017 Last revised: 27 Jul 2018

See all articles by Arun Muralidhar

Arun Muralidhar

AlphaEngine Global Investment Solutions; Georgetown University - McDonough School of Business; George Washington University

Kazuhiko Ohashi

Hitotsubashi University

Sunghwan Shin

Hongik University

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Date Written: March 30, 2015

Abstract

The Capital Asset Pricing Model (CAPM) has been the backbone of asset market finance, even though many academic studies have revealed its limitations, both theoretical and empirical. This paper argues that including liability or benchmark considerations in investment decisions may provide a credible explanation for some of the limitations. In effect, the CAPM is an “absolute wealth”-centric model, driven by the assumption that investors derive utility from absolute wealth. In reality, investors first make investment decisions to ensure sufficient assets to meet obligations, such as future pension payment or future consumption (i.e., liabilities), and focus on relative wealth. Thereafter, many investors hire external managers and evaluate them on performance relative to assigned benchmarks. Interestingly, existing robust literature on, and product offerings for, “liability driven investing,” have not led to a shift in academic theories of asset pricing to reflect the liability perspective. After all, if asset owners choose investments to service liabilities (proxied by benchmarks), it is expected that liabilities or these benchmark proxies will impact asset prices.

Therefore, a shift from an “absolute wealth”-centric to a “liability-centric” or “relative wealth” perspective will create a Relative Asset Pricing Model (RAPM), with the CAPM as a very specialized case of this model. Hence, by examining how liabilities are proxied in practice, the many tests that found the need for additional factors to explain asset behavior might now be rationalized and explained. In this vein, even some behavioral criticisms leveled at CAPM can fit under this liability-centric CAPM-like paradigm. Finally, the asset allocation and portfolio rebalancing implications of this model may better explain some of the risky asset return characteristics such as momentum observed in the market. Therefore, if future research is directed to this compelling liability-centric facet embedded in practitioner behavior and explores this new dimension, RAPM may complement traditional CAPM, and help investors and academicians alike to develop better approaches to asset allocation, rebalancing as well as to asset pricing.

Suggested Citation

Muralidhar, Arun and Ohashi, Kazuhiko and Shin, Sunghwan, The Relative Asset Pricing Model: Implications for Asset Allocation, Rebalancing and Asset Pricing (March 30, 2015). Journal of Financial Perspectives, Vol. 3, No. 1, 2015, Available at SSRN: https://ssrn.com/abstract=3080455

Arun Muralidhar (Contact Author)

AlphaEngine Global Investment Solutions ( email )

Great Falls, VA
United States

HOME PAGE: http://www.mcubeit.com

Georgetown University - McDonough School of Business ( email )

3700 O Street, NW
Washington, DC 20057
United States

HOME PAGE: http://realativityinfinance.wordpress.com

George Washington University ( email )

2121 I Street NW
Washington, DC 20052
United States

Kazuhiko Ohashi

Hitotsubashi University ( email )

Sunghwan Shin

Hongik University ( email )

Seoul
Korea, Republic of (South Korea)

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