Multifactor Models Do Not Explain Deviations from the CAPM.

Download or read book Multifactor Models Do Not Explain Deviations from the CAPM. written by A. Craig Mackinlay and published by . This book was released on 2010 with total page 37 pages. Available in PDF, EPUB and Kindle. Book excerpt: A number of studies have presented evidence rejecting the validity of the Capital Asset Pricing Model (CAPM). This evidence has spawned research into possible explanations. These explanations can be divided into two main categories-- the risk-based alternatives and the nonrisk-based alternatives. The risk-based category includes multifactor asset pricing models developed under the assumptions of investor rationality and perfect capital markets. The nonrisk-based category includes biases introduced in the empirical methodology, the existence of market frictions, or explanations arising from the presence of irrational investors. The distinction between the two categories is important for asset pricing applications such as estimation of the cost of capital. This paper proposes to distinguish between the two categories using ex ante analysis. A framework is developed showing that ex ante one should expect that CAPM deviations due to missing risk factors will be very difficult to empirically detect. In contrast, deviations resulting from nonrisk-based sources will be easy to detect. Examination of empirical results leads to the conclusion that the risk-based alternatives is not the whole story for the CAPM deviations. The implication of this conclusion is that the adoption of empirically developed multifactor asset pricing models may be premature.