How the Inflation Illusion Killed the CAPM

29 Pages Posted: 20 May 2004

See all articles by Randolph B. Cohen

Randolph B. Cohen

Harvard Business School - Finance Unit

Christopher Polk

London School of Economics

Tuomo Vuolteenaho

Arrowstreet Capital, LP; National Bureau of Economic Research (NBER)

Date Written: May 12, 2004

Abstract

Modigliani and Cohn's (1979) hypothesis suggests that time-variation in the level of inflation causes the market's subjective expectation of the future equity premium to deviate systematically from the rational expectation. When inflation is high (low), the rational equity-premium expectation is higher (lower) than the market's subjective expectation. We test the joint hypothesis of Modigliani and Cohn's inflation illusion and the Capital Asset Pricing Model (CAPM). We show that an implication of this joint hypothesis is that the security market line (the relation between an asset's average return and its CAPM beta) should be steeper (shallower) than predicted by the Sharpe-Lintner CAPM when inflation is low (high). Our empirical tests support this hypothesis and offer an explanation for the CAPM's poor performance in the 1950's and 1980's.

Keywords: Inflation illusion, CAPM, beta

JEL Classification: G12, G14, N22

Suggested Citation

Cohen, Randolph B. and Polk, Christopher and Vuolteenaho, Tuomo, How the Inflation Illusion Killed the CAPM (May 12, 2004). Available at SSRN: https://ssrn.com/abstract=548402 or http://dx.doi.org/10.2139/ssrn.548402

Randolph B. Cohen

Harvard Business School - Finance Unit ( email )

Boston, MA 02163
United States
617-495-6674 (Phone)
617-496-6592 (Fax)

Christopher Polk (Contact Author)

London School of Economics ( email )

United Kingdom

HOME PAGE: http://personal.lse.ac.uk/polk/

Tuomo Vuolteenaho

Arrowstreet Capital, LP ( email )

44 Brattle St., 5th Floor
Cambridge, MA 02138
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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