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Linear Beta Pricing with Inefficient Benchmarks

44 Pages Posted: 29 Mar 2006 Last revised: 17 Apr 2013

George Diacogiannis

University of Piraeus - Department of Banking and Financial Management

David Feldman

Banking and Finance, UNSW Business School, UNSW Australia; Financial Research Network (FIRN)

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Date Written: March 11, 2013

Abstract

Current asset pricing models require mean-variance efficient benchmarks, which are generally unavailable because of partial securitization and free float restrictions. We provide a pricing model that uses inefficient benchmarks, a two-beta model, one induced by the benchmark and one adjusting for its inefficiency. While efficient benchmarks induce zero-beta portfolios of the same expected return, any inefficient benchmark induces infinitely many zero-beta portfolios at all expected returns. These make market risk premiums empirically unidentifiable and explain empirically found dead betas and negative market risk premiums. We characterize other misspecifications that arise when using inefficient benchmarks with models that require efficient ones. We provide a space geometry description and analysis of the specifications and misspecifications. We enhance Roll (1980), Roll and Ross’s (1994), and Kandel and Stambaugh’s (1995) results by offering a “Two Fund Theorem,” and by showing the existence of strict theoretical “zero relations” everywhere inside the portfolio frontier.

Keywords: Linear beta pricing, CAPM, expected returns, incomplete information, zero relation

JEL Classification: G10, G12

Suggested Citation

Diacogiannis, George and Feldman, David, Linear Beta Pricing with Inefficient Benchmarks (March 11, 2013). 20th Australasian Finance & Banking Conference 2007 Paper; Forthcoming, Quarterly Journal of Finance; 20th Australasian Finance & Banking Conference 2007 Paper; UNSW Australian School of Business Research Paper No. 2011 BFIN 08. Available at SSRN: https://ssrn.com/abstract=893702 or http://dx.doi.org/10.2139/ssrn.893702

George Diacogiannis

University of Piraeus - Department of Banking and Financial Management ( email )

80 Karaoli & Dimitriou Str.
18534 Piraeus, 185 34 -GR
Greece

David Feldman (Contact Author)

Banking and Finance, UNSW Business School, UNSW Australia ( email )

UNSW Sydney, NSW 2052
Australia
+61 2 9385 5748 (Phone)
+61 2 9385 6347 (Fax)

Financial Research Network (FIRN)

C/- University of Queensland Business School
St Lucia, 4071 Brisbane
Queensland
Australia

HOME PAGE: http://www.firn.org.au

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