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Modern Portfolio Theory and Investment Analysis, 9th Edition by William N. Goetzmann, Stephen J. Brown, Martin J. Gruber, Edwin J. Elton

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14

Nonstandard Forms of Capital Asset Pricing Models

The Capital Asset Pricing Model (CAPM) model developed in the previous chapter would provide a complete description of the behavior of capital markets if each of the assumptions set forth held. The test of the CAPM model is how well it describes reality. But even before we examine these tests, it is useful to develop equilibrium models based on more realistic assumptions. Most of the assumptions underlying the CAPM violate conditions in the real world. This does not mean that we should disregard the CAPM model, for the differences from reality may be sufficiently unimportant that they do not materially affect the explanatory power of the model. On the other hand, the incorporation of alternative, more realistic assumptions into the model has several important benefits. Although the CAPM may describe equilibrium returns on the macro level, it certainly is not descriptive of micro (individual investor) behavior. For example, most individuals and many institutions hold portfolios of risky assets that do not resemble the market portfolio. We might get better insight into investor behavior by examining models developed under alternative and more realistic assumptions. Another reason for examining other equilibrium models is that it allows us to formulate and test alternative explanations of equilibrium returns. The CAPM may work well, but do other models work better and explain discrepancies from the CAPM? Finally, and perhaps most ...

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