Questions and Answers At Least 75 Words each.Please answer th.docx

Questions and Answers: At Least 75 Words each.
Please answer the following questions.
1. What are the differences and similarities between samples
and populations?
2. What are the measures of Central Tendency assumptions?
3. What are measures of Dispersion used for and what are the
assumptions for each?
4. Define collaboration and how you will apply it in Statistics?
(100 Words)
The Capital Asset Pricing Model:
Theory and Evidence
Eugene F. Fama and Kenneth R. French
T he capital asset pricing model (CAPM) of William Sharpe
(1964) and JohnLintner (1965) marks the birth of asset pricing
theory (resulting in aNobel Prize for Sharpe in 1990). Four
decades later, the CAPM is still
widely used in applications, such as estimating the cost of
capital for firms and
evaluating the performance of managed portfolios. It is the
centerpiece of MBA
investment courses. Indeed, it is often the only asset pricing
model taught in these
courses.1
The attraction of the CAPM is that it offers powerful and

intuitively pleasing
predictions about how to measure risk and the relation between
expected return
and risk. Unfortunately, the empirical record of the model is
poor—poor enough
to invalidate the way it is used in applications. The CAPM’s
empirical problems may
reflect theoretical failings, the result of many simplifying
assumptions. But they may
also be caused by difficulties in implementing valid tests of the
model. For example,
the CAPM says that the risk of a stock should be measured
relative to a compre-
hensive “market portfolio” that in principle can include not just
traded financial
assets, but also consumer durables, real estate and human
capital. Even if we take
a narrow view of the model and limit its purview to traded
financial assets, is it
1 Although every asset pricing model is a capital asset pricing
model, the finance profession reserves the
acronym CAPM for the specific model of Sharpe (1964),
Lintner (1965) and Black (1972) discussed
here. Thus, throughout the paper we refer to the Sharpe-Lintner-
Black model as the CAPM.
y Eugene F. Fama is Robert R. McCormick Distinguished
Service Professor of Finance,
Graduate School of Business, University of Chicago, Chicago,
Illinois. Kenneth R. French is
Carl E. and Catherine M. Heidt Professor of Finance, Tuck
School of Business, Dartmouth
College, Hanover, New Hampshire. Their e-mail addresses are
�[email protected]
edu� and �[email protected]�, respectively.

Journal of Economic Perspectives—Volume 18, Number 3—
Summer 2004 —Pages 25– 46
legitimate to limit further the market portfolio to U.S. common
stocks (a typical
choice), or should the market be expanded to include bonds, and
other financial
assets, perhaps around the world? In the end, we argue that
whether the model’s
problems reflect weaknesses in the theory or in its empirical
implementation, the
failure of the CAPM in empirical tests implies that most
applications of the model
are invalid.
We begin by outlining the logic of the CAPM, focusing on its
predictions about
risk and expected return. We then review the history of
empirical work and what it
says about shortcomings of the CAPM that pose challenges to
be explained by
alternative models.
The Logic of the CAPM
The CAPM builds on the model of portfolio choice developed
by Harry
Markowitz (1959). In Markowitz’s model, an investor selects a
portfolio at time
t � 1 that produces a stochastic return at t. The model assumes
investors are risk
averse and, when choosing among portfolios, they care only
about the mean and

variance of their one-period investment return. As a result,
investors choose “mean-
variance-efficient” portfolios, in the sense that the portfolios 1)
minimize the
variance of portfolio return, given expected return, and 2)
maximize expected
return, given variance. Thus, the Markowitz approach is often
called a “mean-
variance model.”
The portfolio model provides an algebraic condition on asset
weights in mean-
variance-efficient portfolios. The CAPM turns this algebraic
statement into a testable
prediction about the relation between risk and expected return
by identifying a
portfolio that must be efficient if asset prices are to clear the
market of all assets.
Sharpe (1964) and Lintner (1965) add two key assumptions to
the Markowitz
model to identify a portfolio that must be mean-variance-
efficient. The first assump-
tion is complete agreement: given market clearing asset prices
at t � 1, investors agree
on the joint distribution of asset returns from t � 1 to t. And
this distribution is the
true one—that is, it is the distribution from which the returns
we use to test the
model are drawn. The second assumption is that there is
borrowing and lending at a
risk-free rate, which is the same for all investors and does not
depend on the amount
borrowed or lent.
Figure 1 describes portfolio opportunities and tells the CAPM

story. The
horizontal axis shows portfolio risk, measured by the standard
deviation of portfolio
return; the vertical axis shows expected return. The curve abc,
which is called the
minimum variance frontier, traces combinations of expected
return and risk for
portfolios of risky assets that minimize return variance at
different levels of ex-
pected return. (These portfolios do not include risk-free
borrowing and lending.)
The tradeoff between risk and expected return for minimum
variance portfolios is
apparent. For example, an investor who wants a high expected
return, perhaps at
point a, must accept high volatility. At point T, the investor can
have an interme-
26 Journal of Economic Perspectives
diate expected return with lower volatility. If there is no risk-
free borrowing or
lending, only portfolios above b along abc are mean-variance-
efficient, since these
portfolios also maximize expected return, given their return
variances.
Adding risk-free borrowing and lending turns the efficient set
into a straight
line. Consider a portfolio that invests the proportion x of
portfolio funds in a
risk-free security and 1 � x in some portfolio g. If all funds are
invested in the
risk-free security—that is, they are loaned at the risk-free rate

of interest—the result
is the point Rf in Figure 1, a portfolio with zero variance and a
risk-free rate of
return. Combinations of risk-free lending and positive
investment in g plot on the
straight line between Rf and g. Points to the right of g on the
line represent
borrowing at the risk-free rate, with the proceeds from the
borrowing used to
increase investment in portfolio g. In short, portfolios that
combine risk-free
lending or borrowing with some risky portfolio g plot along a
straight line from Rf
through g in Figure 1.2
2 Formally, the return, expected return and standard deviation
of return on portfolios of the risk-free
asset f and a risky portfolio g vary with x, the proportion of
portfolio funds invested in f, as
Rp � xRf � �1 � x�Rg ,
E�Rp � � xRf � �1 � x�E�Rg �,
� �Rp � � �1 � x�� Rg �, x � 1.0,
which together imply that the portfolios plot along the line from
Rf through g in Figure 1.
Figure 1
Investment Opportunities
Minimum variance
frontier for risky assets
g

s(R )
a
c
b
T
E(R )
R f
Mean-variance-
efficient frontier
with a riskless asset
Eugene F. Fama and Kenneth R. French 27
To obtain the mean-variance-efficient portfolios available with
risk-free bor-
rowing and lending, one swings a line from Rf in Figure 1 up
and to the left as far
as possible, to the tangency portfolio T. We can then see that all
efficient portfolios
are combinations of the risk-free asset (either risk-free
borrowing or lending) and
a single risky tangency portfolio, T. This key result is Tobin’s
(1958) “separation
theorem.”

The punch line of the CAPM is now straightforward. With
complete agreement
about distributions of returns, all investors see the same
opportunity set (Figure 1),
and they combine the same risky tangency portfolio T with risk-
free lending or
borrowing. Since all investors hold the same portfolio T of risky
assets, it must be
the value-weight market portfolio of risky assets. Specifically,
each risky asset’s
weight in the tangency portfolio, which we now call M (for the
“market”), must be
the total market value of all outstanding units of the asset
divided by the total
market value of all risky assets. In addition, the risk-free rate
must be set (along with
the prices of risky assets) to clear the market for risk-free
borrowing and lending.
In short, the CAPM assumptions imply that the market portfolio
M must be on
the minimum variance frontier if the asset market is to clear.
This means that the
algebraic relation that holds for any minimum variance portfolio
must hold for the
market portfolio. Specifically, if there are N risky assets,
�Minimum Variance Condition for M � E�Ri � � E�RZM �
� �E�RM � � E�RZM ��iM , i � 1, . . . , N.
In this equation, E(Ri) is the expected return on asset i, and
�iM, the market beta
of asset i, is the covariance of its return with the market return
divided by the
variance of the market return,

�Market Beta� �iM �
cov�Ri , RM �
�2�RM �
.
The first term on the right-hand side of the minimum variance
condition,
E(RZM), is the expected return on assets that have market betas
equal to zero,
which means their returns are uncorrelated with the market
return. The second
term is a risk premium—the market beta of asset i, �iM, times
the premium per
unit of beta, which is the expected market return, E(RM), minus
E(RZM).
Since the market beta of asset i is also the slope in the
regression of its return
on the market return, a common (and correct) interpretation of
beta is that it
measures the sensitivity of the asset’s return to variation in the
market return. But
there is another interpretation of beta more in line with the
spirit of the portfolio
model that underlies the CAPM. The risk of the market
portfolio, as measured by
the variance of its return (the denominator of �iM), is a
weighted average of the
covariance risks of the assets in M (the numerators of �iM for
different assets).

Thus, �iM is the covariance risk of asset i in M measured
relative to the average
covariance risk of assets, which is just the variance of the
market return.3 In
economic terms, �iM is proportional to the risk each dollar
invested in asset i
contributes to the market portfolio.
The last step in the development of the Sharpe-Lintner model is
to use the
assumption of risk-free borrowing and lending to nail down
E(RZM), the expected
return on zero-beta assets. A risky asset’s return is uncorrelated
with the market
return—its beta is zero—when the average of the asset’s
covariances with the
returns on other assets just offsets the variance of the asset’s
return. Such a risky
asset is riskless in the market portfolio in the sense that it
contributes nothing to the
variance of the market return.
When there is risk-free borrowing and lending, the expected
return on assets
that are uncorrelated with the market return, E(RZM), must
equal the risk-free rate,
Rf. The relation between expected return and beta then becomes
the familiar
Sharpe-Lintner CAPM equation,
�Sharpe-Lintner CAPM� E�Ri � � Rf � �E�RM � � Rf
�]�iM , i � 1, . . . , N.
In words, the expected return on any asset i is the risk-free
interest rate, Rf , plus a

risk premium, which is the asset’s market beta, �iM, times the
premium per unit of
beta risk, E(RM) � Rf.
Unrestricted risk-free borrowing and lending is an unrealistic
assumption.
Fischer Black (1972) develops a version of the CAPM without
risk-free borrowing or
lending. He shows that the CAPM’s key result—that the market
portfolio is mean-
variance-efficient— can be obtained by instead allowing
unrestricted short sales of
risky assets. In brief, back in Figure 1, if there is no risk-free
asset, investors select
portfolios from along the mean-variance-efficient frontier from
a to b. Market
clearing prices imply that when one weights the efficient
portfolios chosen by
investors by their (positive) shares of aggregate invested
wealth, the resulting
portfolio is the market portfolio. The market portfolio is thus a
portfolio of the
efficient portfolios chosen by investors. With unrestricted short
selling of risky
assets, portfolios made up of efficient portfolios are themselves
efficient. Thus, the
market portfolio is efficient, which means that the minimum
variance condition for
M given above holds, and it is the expected return-risk relation
of the Black CAPM.
The relations between expected return and market beta of the
Black and
Sharpe-Lintner versions of the CAPM differ only in terms of
what each says about
E(RZM), the expected return on assets uncorrelated with the

market. The Black
version says only that E(RZM) must be less than the expected
market return, so the
3 Formally, if xiM is the weight of asset i in the market
portfolio, then the variance of the portfolio’s
return is
�2�RM � � Cov�RM , RM � � Cov� �
i�1
N
xiM Ri , RM� � �
i�1
N
xiM Cov�Ri , RM �.
The Capital Asset Pricing Model: Theory and Evidence 29
premium for beta is positive. In contrast, in the Sharpe-Lintner
version of the
model, E(RZM) must be the risk-free interest rate, Rf , and the
premium per unit of
beta risk is E(RM) � Rf.
The assumption that short selling is unrestricted is as unrealistic
as unre-
stricted risk-free borrowing and lending. If there is no risk-free
asset and short sales
of risky assets are not allowed, mean-variance investors still
choose efficient

portfolios—points above b on the abc curve in Figure 1. But
when there is no short
selling of risky assets and no risk-free asset, the algebra of
portfolio efficiency says
that portfolios made up of efficient portfolios are not typically
efficient. This means
that the market portfolio, which is a portfolio of the efficient
portfolios chosen by
investors, is not typically efficient. And the CAPM relation
between expected return
and market beta is lost. This does not rule out predictions about
expected return
and betas with respect to other efficient portfolios—if theory
can specify portfolios
that must be efficient if the market is to clear. But so far this
has proven impossible.
In short, the familiar CAPM equation relating expected asset
returns to their
market betas is just an application to the market portfolio of the
relation between
expected return and portfolio beta that holds in any mean-
variance-efficient port-
folio. The efficiency of the market portfolio is based on many
unrealistic assump-
tions, including complete agreement and either unrestricted
risk-free borrowing
and lending or unrestricted short selling of risky assets. But all
interesting models
involve unrealistic simplifications, which is why they must be
tested against data.
Early Empirical Tests
Tests of the CAPM are based on three implications of the
relation between

expected return and market beta implied by the model. First,
expected returns on
all assets are linearly related to their betas, and no other
variable has marginal
explanatory power. Second, the beta premium is positive,
meaning that the ex-
pected return on the market portfolio exceeds the expected
return on assets whose
returns are uncorrelated with the market return. Third, in the
Sharpe-Lintner
version of the model, assets uncorrelated with the market have
expected returns
equal to the risk-free interest rate, and the beta premium is the
expected market
return minus the risk-free rate. Most tests of these predictions
use either cross-
section or time-series regressions. Both approaches date to early
tests of the model.
Tests on Risk Premiums
The early cross-section regression tests focus on the Sharpe-
Lintner model’s
predictions about the intercept and slope in the relation between
expected return
and market beta. The approach is to regress a cross-section of
average asset returns
on estimates of asset betas. The model predicts that the
intercept in these regres-
sions is the risk-free interest rate, Rf , and the coefficient on
beta is the expected
return on the market in excess of the risk-free rate, E(RM) �
Rf.
Two problems in these tests quickly became apparent. First,
estimates of beta

for individual assets are imprecise, creating a measurement
error problem when
they are used to explain average returns. Second, the regression
residuals have
common sources of variation, such as industry effects in
average returns. Positive
correlation in the residuals produces downward bias in the usual
ordinary least
squares estimates of the standard errors of the cross-section
regression slopes.
To improve the precision of estimated betas, researchers such as
Blume
(1970), Friend and Blume (1970) and Black, Jensen and Scholes
(1972) work with
portfolios, rather than individual securities. Since expected
returns and market
betas combine in the same way in portfolios, if the CAPM
explains security returns
it also explains portfolio returns.4 Estimates of beta for
diversified portfolios are
more precise than estimates for individual securities. Thus,
using portfolios in
cross-section regressions of average returns on betas reduces
the critical errors in
variables problem. Grouping, however, shrinks the range of
betas and reduces
statistical power. To mitigate this problem, researchers sort
securities on beta when
forming portfolios; the first portfolio contains securities with
the lowest betas, and

so on, up to the last portfolio with the highest beta assets. This
sorting procedure
is now standard in empirical tests.
Fama and MacBeth (1973) propose a method for addressing the
inference
problem caused by correlation of the residuals in cross-section
regressions. Instead
of estimating a single cross-section regression of average
monthly returns on betas,
they estimate month-by-month cross-section regressions of
monthly returns on
betas. The times-series means of the monthly slopes and
intercepts, along with the
standard errors of the means, are then used to test whether the
average premium
for beta is positive and whether the average return on assets
uncorrelated with the
market is equal to the average risk-free interest rate. In this
approach, the standard
errors of the average intercept and slope are determined by the
month-to-month
variation in the regression coefficients, which fully captures the
effects of residual
correlation on variation in the regression coefficients, but
sidesteps the problem of
actually estimating the correlations. The residual correlations
are, in effect, cap-
tured via repeated sampling of the regression coefficients. This
approach also
becomes standard in the literature.
Jensen (1968) was the first to note that the Sharpe-Lintner
version of the
4 Formally, if xip, i � 1, . . . , N, are the weights for assets in

some portfolio p, the expected return and
market beta for the portfolio are related to the expected returns
and betas of assets as
E�Rp � � �
i�1
N
xip E�Ri �, and �pM � �
i�1
N
xip�pM .
Thus, the CAPM relation between expected return and beta,
E�Ri � � E�Rf � � �E�RM � � E�Rf ��iM ,
holds when asset i is a portfolio, as well as when i is an
individual security.
relation between expected return and market beta also implies a
time-series re-
gression test. The Sharpe-Lintner CAPM says that the expected
value of an asset’s
excess return (the asset’s return minus the risk-free interest
rate, Rit � Rft) is
completely explained by its expected CAPM risk premium (its
beta times the
expected value of RMt � Rft). This implies that “Jensen’s

alpha,” the intercept term
in the time-series regression,
�Time-Series Regression� Rit � Rft � �i � �iM �RMt � Rft
� � �it ,
is zero for each asset.
The early tests firmly reject the Sharpe-Lintner version of the
CAPM. There is
a positive relation between beta and average return, but it is too
“flat.” Recall that,
in cross-section regressions, the Sharpe-Lintner model predicts
that the intercept is
the risk-free rate and the coefficient on beta is the expected
market return in excess
of the risk-free rate, E(RM) � Rf. The regressions consistently
find that the
intercept is greater than the average risk-free rate (typically
proxied as the return
on a one-month Treasury bill), and the coefficient on beta is
less than the average
excess market return (proxied as the average return on a
portfolio of U.S. common
stocks minus the Treasury bill rate). This is true in the early
tests, such as Douglas
(1968), Black, Jensen and Scholes (1972), Miller and Scholes
(1972), Blume and
Friend (1973) and Fama and MacBeth (1973), as well as in more
recent cross-
section regression tests, like Fama and French (1992).
The evidence that the relation between beta and average return
is too flat is
confirmed in time-series tests, such as Friend and Blume
(1970), Black, Jensen and

Scholes (1972) and Stambaugh (1982). The intercepts in time-
series regressions of
excess asset returns on the excess market return are positive for
assets with low betas
and negative for assets with high betas.
Figure 2 provides an updated example of the evidence. In
December of each
year, we estimate a preranking beta for every NYSE (1928 –
2003), AMEX (1963–
2003) and NASDAQ (1972–2003) stock in the CRSP (Center for
Research in
Security Prices of the University of Chicago) database, using
two to five years (as
available) of prior monthly returns.5 We then form ten value-
weight portfolios
based on these preranking betas and compute their returns for
the next twelve
months. We repeat this process for each year from 1928 to
2003. The result is
912 monthly returns on ten beta-sorted portfolios. Figure 2 plots
each portfolio’s
average return against its postranking beta, estimated by
regressing its monthly
returns for 1928 –2003 on the return on the CRSP value-weight
portfolio of U.S.
common stocks.
The Sharpe-Lintner CAPM predicts that the portfolios plot
along a straight
5 To be included in the sample for year t, a security must have
market equity data (price times shares
outstanding) for December of t � 1, and CRSP must classify it
as ordinary common equity. Thus, we
exclude securities such as American Depository Receipts

(ADRs) and Real Estate Investment Trusts
(REITs).
line, with an intercept equal to the risk-free rate, Rf , and a
slope equal to the
expected excess return on the market, E(RM) � Rf. We use the
average one-month
Treasury bill rate and the average excess CRSP market return
for 1928 –2003 to
estimate the predicted line in Figure 2. Confirming earlier
evidence, the relation
between beta and average return for the ten portfolios is much
flatter than the
Sharpe-Lintner CAPM predicts. The returns on the low beta
portfolios are too high,
and the returns on the high beta portfolios are too low. For
example, the predicted
return on the portfolio with the lowest beta is 8.3 percent per
year; the actual return
is 11.1 percent. The predicted return on the portfolio with the
highest beta is
16.8 percent per year; the actual is 13.7 percent.
Although the observed premium per unit of beta is lower than
the Sharpe-
Lintner model predicts, the relation between average return and
beta in Figure 2
is roughly linear. This is consistent with the Black version of
the CAPM, which
predicts only that the beta premium is positive. Even this less
restrictive model,
however, eventually succumbs to the data.

Testing Whether Market Betas Explain Expected Returns
The Sharpe-Lintner and Black versions of the CAPM share the
prediction that
the market portfolio is mean-variance-efficient. This implies
that differences in
expected return across securities and portfolios are entirely
explained by differ-
ences in market beta; other variables should add nothing to the
explanation of
expected return. This prediction plays a prominent role in tests
of the CAPM. In
the early work, the weapon of choice is cross-section
regressions.
In the framework of Fama and MacBeth (1973), one simply adds
predeter-
mined explanatory variables to the month-by-month cross-
section regressions of
Figure 2
Average Annualized Monthly Return versus Beta for Value
Weight Portfolios
Formed on Prior Beta, 1928 –2003
Average returns
predicted by the
CAPM
0.5
6
8
10

12
14
16
18
0.7 0.9 1.1 1.3 1.5 1.7 1.9
A
ve
ra
ge
a
n
n
u
al
iz
ed
m
o
n
th
ly
r

et
u
rn
(
%
)
returns on beta. If all differences in expected return are
explained by beta, the
average slopes on the additional variables should not be reliably
different from
zero. Clearly, the trick in the cross-section regression approach
is to choose specific
additional variables likely to expose any problems of the CAPM
prediction that,
because the market portfolio is efficient, market betas suffice to
explain expected
asset returns.
For example, in Fama and MacBeth (1973) the additional
variables are
squared market betas (to test the prediction that the relation
between expected
return and beta is linear) and residual variances from
regressions of returns on the
market return (to test the prediction that market beta is the only
measure of risk
needed to explain expected returns). These variables do not add
to the explanation

of average returns provided by beta. Thus, the results of Fama
and MacBeth (1973)
are consistent with the hypothesis that their market proxy—an
equal-weight port-
folio of NYSE stocks—is on the minimum variance frontier.
The hypothesis that market betas completely explain expected
returns can also
be tested using time-series regressions. In the time-series
regression described
above (the excess return on asset i regressed on the excess
market return), the
intercept is the difference between the asset’s average excess
return and the excess
return predicted by the Sharpe-Lintner model, that is, beta times
the average excess
market return. If the model holds, there is no way to group
assets into portfolios
whose intercepts are reliably different from zero. For example,
the intercepts for a
portfolio of stocks with high ratios of earnings to price and a
portfolio of stocks with
low earning-price ratios should both be zero. Thus, to test the
hypothesis that
market betas suffice to explain expected returns, one estimates
the time-series
regression for a set of assets (or portfolios) and then jointly
tests the vector of
regression intercepts against zero. The trick in this approach is
to choose the
left-hand-side assets (or portfolios) in a way likely to expose
any shortcoming of the
CAPM prediction that market betas suffice to explain expected
asset returns.
In early applications, researchers use a variety of tests to

determine whether
the intercepts in a set of time-series regressions are all zero.
The tests have the same
asymptotic properties, but there is controversy about which has
the best small
sample properties. Gibbons, Ross and Shanken (1989) settle the
debate by provid-
ing an F-test on the intercepts that has exact small-sample
properties. They also
show that the test has a simple economic interpretation. In
effect, the test con-
structs a candidate for the tangency portfolio T in Figure 1 by
optimally combining
the market proxy and the left-hand-side assets of the time-series
regressions. The
estimator then tests whether the efficient set provided by the
combination of this
tangency portfolio and the risk-free asset is reliably superior to
the one obtained by
combining the risk-free asset with the market proxy alone. In
other words, the
Gibbons, Ross and Shanken statistic tests whether the market
proxy is the tangency
portfolio in the set of portfolios that can be constructed by
combining the market
portfolio with the specific assets used as dependent variables in
the time-series
regressions.
Enlightened by this insight of Gibbons, Ross and Shanken
(1989), one can see

a similar interpretation of the cross-section regression test of
whether market betas
suffice to explain expected returns. In this case, the test is
whether the additional
explanatory variables in a cross-section regression identify
patterns in the returns
on the left-hand-side assets that are not explained by the assets’
market betas. This
amounts to testing whether the market proxy is on the minimum
variance frontier
that can be constructed using the market proxy and the left-
hand-side assets
included in the tests.
An important lesson from this discussion is that time-series and
cross-section
regressions do not, strictly speaking, test the CAPM. What is
literally tested is
whether a specific proxy for the market portfolio (typically a
portfolio of U.S.
common stocks) is efficient in the set of portfolios that can be
constructed from it
and the left-hand-side assets used in the test. One might
conclude from this that the
CAPM has never been tested, and prospects for testing it are not
good because
1) the set of left-hand-side assets does not include all
marketable assets, and 2) data
for the true market portfolio of all assets are likely beyond
reach (Roll, 1977; more
on this later). But this criticism can be leveled at tests of any
economic model when
the tests are less than exhaustive or when they use proxies for
the variables called
for by the model.

The bottom line from the early cross-section regression tests of
the CAPM,
such as Fama and MacBeth (1973), and the early time-series
regression tests, like
Gibbons (1982) and Stambaugh (1982), is that standard market
proxies seem to be
on the minimum variance frontier. That is, the central
predictions of the Black
version of the CAPM, that market betas suffice to explain
expected returns and that
the risk premium for beta is positive, seem to hold. But the
more specific prediction
of the Sharpe-Lintner CAPM that the premium per unit of beta
is the expected
market return minus the risk-free interest rate is consistently
rejected.
The success of the Black version of the CAPM in early tests
produced a
consensus that the model is a good description of expected
returns. These early
results, coupled with the model’s simplicity and intuitive
appeal, pushed the CAPM
to the forefront of finance.
Recent Tests
Starting in the late 1970s, empirical work appears that
challenges even the
Black version of the CAPM. Specifically, evidence mounts that
much of the varia-
tion in expected return is unrelated to market beta.
The first blow is Basu’s (1977) evidence that when common
stocks are sorted
on earnings-price ratios, future returns on high E/P stocks are

higher than pre-
dicted by the CAPM. Banz (1981) documents a size effect:
when stocks are sorted
on market capitalization (price times shares outstanding),
average returns on small
stocks are higher than predicted by the CAPM. Bhandari (1988)
finds that high
debt-equity ratios (book value of debt over the market value of
equity, a measure of
leverage) are associated with returns that are too high relative
to their market betas.
Finally, Statman (1980) and Rosenberg, Reid and Lanstein
(1985) document that
stocks with high book-to-market equity ratios (B/M, the ratio of
the book value of
a common stock to its market value) have high average returns
that are not
captured by their betas.
There is a theme in the contradictions of the CAPM summarized
above. Ratios
involving stock prices have information about expected returns
missed by market
betas. On reflection, this is not surprising. A stock’s price
depends not only on the
expected cash flows it will provide, but also on the expected
returns that discount
expected cash flows back to the present. Thus, in principle, the
cross-section of
prices has information about the cross-section of expected
returns. (A high ex-

pected return implies a high discount rate and a low price.) The
cross-section of
stock prices is, however, arbitrarily affected by differences in
scale (or units). But
with a judicious choice of scaling variable X, the ratio X/P can
reveal differences
in the cross-section of expected stock returns. Such ratios are
thus prime candidates
to expose shortcomings of asset pricing models—in the case of
the CAPM, short-
comings of the prediction that market betas suffice to explain
expected returns
(Ball, 1978). The contradictions of the CAPM summarized
above suggest that
earnings-price, debt-equity and book-to-market ratios indeed
play this role.
Fama and French (1992) update and synthesize the evidence on
the empirical
failures of the CAPM. Using the cross-section regression
approach, they confirm
that size, earnings-price, debt-equity and book-to-market ratios
add to the explana-
tion of expected stock returns provided by market beta. Fama
and French (1996)
reach the same conclusion using the time-series regression
approach applied to
portfolios of stocks sorted on price ratios. They also find that
different price ratios
have much the same information about expected returns. This is
not surprising
given that price is the common driving force in the price ratios,
and the numerators
are just scaling variables used to extract the information in
price about expected
returns.

Fama and French (1992) also confirm the evidence (Reinganum,
1981; Stam-
baugh, 1982; Lakonishok and Shapiro, 1986) that the relation
between average
return and beta for common stocks is even flatter after the
sample periods used in
the early empirical work on the CAPM. The estimate of the beta
premium is,
however, clouded by statistical uncertainty (a large standard
error). Kothari, Shan-
ken and Sloan (1995) try to resuscitate the Sharpe-Lintner
CAPM by arguing that
the weak relation between average return and beta is just a
chance result. But the
strong evidence that other variables capture variation in
expected return missed by
beta makes this argument irrelevant. If betas do not suffice to
explain expected
returns, the market portfolio is not efficient, and the CAPM is
dead in its tracks.
Evidence on the size of the market premium can neither save the
model nor further
doom it.
The synthesis of the evidence on the empirical problems of the
CAPM pro-
vided by Fama and French (1992) serves as a catalyst, marking
the point when it is
generally acknowledged that the CAPM has potentially fatal
problems. Research
then turns to explanations.

One possibility is that the CAPM’s problems are spurious, the
result of data
dredging—publication-hungry researchers scouring the data and
unearthing con-
tradictions that occur in specific samples as a result of chance.
A standard response
to this concern is to test for similar findings in other samples.
Chan, Hamao and
Lakonishok (1991) find a strong relation between book-to-
market equity (B/M)
and average return for Japanese stocks. Capaul, Rowley and
Sharpe (1993) observe
a similar B/M effect in four European stock markets and in
Japan. Fama and
French (1998) find that the price ratios that produce problems
for the CAPM in
U.S. data show up in the same way in the stock returns of
twelve non-U.S. major
markets, and they are present in emerging market returns. This
evidence suggests
that the contradictions of the CAPM associated with price ratios
are not sample
specific.
Explanations: Irrational Pricing or Risk
Among those who conclude that the empirical failures of the
CAPM are fatal,
two stories emerge. On one side are the behavioralists. Their
view is based on
evidence that stocks with high ratios of book value to market
price are typically
firms that have fallen on bad times, while low B/M is associated
with growth firms
(Lakonishok, Shleifer and Vishny, 1994; Fama and French,

1995). The behavior-
alists argue that sorting firms on book-to-market ratios exposes
investor overreac-
tion to good and bad times. Investors overextrapolate past
performance, resulting
in stock prices that are too high for growth (low B/M) firms and
too low for
distressed (high B/M, so-called value) firms. When the
overreaction is eventually
corrected, the result is high returns for value stocks and low
returns for growth
stocks. Proponents of this view include DeBondt and Thaler
(1987), Lakonishok,
Shleifer and Vishny (1994) and Haugen (1995).
The second story for explaining the empirical contradictions of
the CAPM is
that they point to the need for a more complicated asset pricing
model. The CAPM
is based on many unrealistic assumptions. For example, the
assumption that
investors care only about the mean and variance of one-period
portfolio returns is
extreme. It is reasonable that investors also care about how their
portfolio return
covaries with labor income and future investment opportunities,
so a portfolio’s
return variance misses important dimensions of risk. If so,
market beta is not a
complete description of an asset’s risk, and we should not be
surprised to find that
differences in expected return are not completely explained by
differences in beta.
In this view, the search should turn to asset pricing models that
do a better job
explaining average returns.

Merton’s (1973) intertemporal capital asset pricing model
(ICAPM) is a
natural extension of the CAPM. The ICAPM begins with a
different assumption
about investor objectives. In the CAPM, investors care only
about the wealth their
portfolio produces at the end of the current period. In the
ICAPM, investors are
concerned not only with their end-of-period payoff, but also
with the opportunities
they will have to consume or invest the payoff. Thus, when
choosing a portfolio at
time t � 1, ICAPM investors consider how their wealth at t
might vary with future
state variables, including labor income, the prices of
consumption goods and the
nature of portfolio opportunities at t, and expectations about the
labor income,
consumption and investment opportunities to be available after
t.
Like CAPM investors, ICAPM investors prefer high expected
return and low
return variance. But ICAPM investors are also concerned with
the covariances of
portfolio returns with state variables. As a result, optimal
portfolios are “multifactor
efficient,” which means they have the largest possible expected
returns, given their
return variances and the covariances of their returns with the

relevant state
variables.
Fama (1996) shows that the ICAPM generalizes the logic of the
CAPM. That is,
if there is risk-free borrowing and lending or if short sales of
risky assets are allowed,
market clearing prices imply that the market portfolio is
multifactor efficient.
Moreover, multifactor efficiency implies a relation between
expected return and
beta risks, but it requires additional betas, along with a market
beta, to explain
expected returns.
An ideal implementation of the ICAPM would specify the state
variables that
affect expected returns. Fama and French (1993) take a more
indirect approach,
perhaps more in the spirit of Ross’s (1976) arbitrage pricing
theory. They argue
that though size and book-to-market equity are not themselves
state variables, the
higher average returns on small stocks and high book-to-market
stocks reflect
unidentified state variables that produce undiversifiable risks
(covariances) in
returns that are not captured by the market return and are priced
separately from
market betas. In support of this claim, they show that the
returns on the stocks of
small firms covary more with one another than with returns on
the stocks of large
firms, and returns on high book-to-market (value) stocks covary
more with one
another than with returns on low book-to-market (growth)

stocks. Fama and
French (1995) show that there are similar size and book-to-
market patterns in the
covariation of fundamentals like earnings and sales.
Based on this evidence, Fama and French (1993, 1996) propose
a three-factor
model for expected returns,
�Three-Factor Model� E�Rit � � Rft � �iM �E�RMt � �
Rft �
� �is E�SMBt � � �ih E�HMLt �.
In this equation, SMBt (small minus big) is the difference
between the returns on
diversified portfolios of small and big stocks, HMLt (high
minus low) is the
difference between the returns on diversified portfolios of high
and low B/M
stocks, and the betas are slopes in the multiple regression of Rit
� Rft on RMt � Rft,
SMBt and HMLt.
For perspective, the average value of the market premium RMt
� Rft for
1927–2003 is 8.3 percent per year, which is 3.5 standard errors
from zero. The
average values of SMBt, and HMLt are 3.6 percent and 5.0
percent per year, and
they are 2.1 and 3.1 standard errors from zero. All three

premiums are volatile, with
annual standard deviations of 21.0 percent (RMt � Rft), 14.6
percent (SMBt) and
14.2 percent (HMLt) per year. Although the average values of
the premiums are
large, high volatility implies substantial uncertainty about the
true expected
premiums.
One implication of the expected return equation of the three-
factor model is
that the intercept �i in the time-series regression,
Rit � Rft � �i � �iM �RMt � Rft � � �is SMBt � �ih
HMLt � �it ,
is zero for all assets i. Using this criterion, Fama and French
(1993, 1996) find that
the model captures much of the variation in average return for
portfolios formed
on size, book-to-market equity and other price ratios that cause
problems for the
CAPM. Fama and French (1998) show that an international
version of the model
performs better than an international CAPM in describing
average returns on
portfolios formed on scaled price variables for stocks in 13
major markets.
The three-factor model is now widely used in empirical research
that requires
a model of expected returns. Estimates of �i from the time-
series regression above
are used to calibrate how rapidly stock prices respond to new
information (for
example, Loughran and Ritter, 1995; Mitchell and Stafford,

2000). They are also
used to measure the special information of portfolio managers,
for example, in
Carhart’s (1997) study of mutual fund performance. Among
practitioners like
Ibbotson Associates, the model is offered as an alternative to
the CAPM for
estimating the cost of equity capital.
From a theoretical perspective, the main shortcoming of the
three-factor
model is its empirical motivation. The small-minus-big (SMB)
and high-minus-low
(HML) explanatory returns are not motivated by predictions
about state variables
of concern to investors. Instead they are brute force constructs
meant to capture
the patterns uncovered by previous work on how average stock
returns vary with size
and the book-to-market equity ratio.
But this concern is not fatal. The ICAPM does not require that
the additional
portfolios used along with the market portfolio to explain
expected returns
“mimic” the relevant state variables. In both the ICAPM and the
arbitrage pricing
theory, it suffices that the additional portfolios are well
diversified (in the termi-
nology of Fama, 1996, they are multifactor minimum variance)
and that they are
sufficiently different from the market portfolio to capture
covariation in returns
and variation in expected returns missed by the market
portfolio. Thus, adding
diversified portfolios that capture covariation in returns and

variation in average
returns left unexplained by the market is in the spirit of both the
ICAPM and the
Ross’s arbitrage pricing theory.
The behavioralists are not impressed by the evidence for a risk-
based expla-
nation of the failures of the CAPM. They typically concede that
the three-factor
model captures covariation in returns missed by the market
return and that it picks
up much of the size and value effects in average returns left
unexplained by the
CAPM. But their view is that the average return premium
associated with the
model’s book-to-market factor—which does the heavy lifting in
the improvements
to the CAPM—is itself the result of investor overreaction that
happens to be
correlated across firms in a way that just looks like a risk story.
In short, in the
behavioral view, the market tries to set CAPM prices, and
violations of the CAPM
are due to mispricing.
The conflict between the behavioral irrational pricing story and
the rational
risk story for the empirical failures of the CAPM leaves us at a
timeworn impasse.
Fama (1970) emphasizes that the hypothesis that prices properly
reflect available

information must be tested in the context of a model of expected
returns, like the
CAPM. Intuitively, to test whether prices are rational, one must
take a stand on what
the market is trying to do in setting prices—that is, what is risk
and what is the
relation between expected return and risk? When tests reject the
CAPM, one
cannot say whether the problem is its assumption that prices are
rational (the
behavioral view) or violations of other assumptions that are also
necessary to
produce the CAPM (our position).
Fortunately, for some applications, the way one uses the three-
factor model
does not depend on one’s view about whether its average return
premiums are the
rational result of underlying state variable risks, the result of
irrational investor
behavior or sample specific results of chance. For example,
when measuring the
response of stock prices to new information or when evaluating
the performance of
managed portfolios, one wants to account for known patterns in
returns and
average returns for the period examined, whatever their source.
Similarly, when
estimating the cost of equity capital, one might be unconcerned
with whether
expected return premiums are rational or irrational since they
are in either case
part of the opportunity cost of equity capital (Stein, 1996). But
the cost of capital
is forward looking, so if the premiums are sample specific they
are irrelevant.

The three-factor model is hardly a panacea. Its most serious
problem is the
momentum effect of Jegadeesh and Titman (1993). Stocks that
do well relative to
the market over the last three to twelve months tend to continue
to do well for the
next few months, and stocks that do poorly continue to do
poorly. This momentum
effect is distinct from the value effect captured by book-to-
market equity and other
price ratios. Moreover, the momentum effect is left unexplained
by the three-factor
model, as well as by the CAPM. Following Carhart (1997), one
response is to add
a momentum factor (the difference between the returns on
diversified portfolios of
short-term winners and losers) to the three-factor model. This
step is again legiti-
mate in applications where the goal is to abstract from known
patterns in average
returns to uncover information-specific or manager-specific
effects. But since the
momentum effect is short-lived, it is largely irrelevant for
estimates of the cost of
equity capital.
Another strand of research points to problems in both the three-
factor model
and the CAPM. Frankel and Lee (1998), Dechow, Hutton and
Sloan (1999),
Piotroski (2000) and others show that in portfolios formed on
price ratios like

book-to-market equity, stocks with higher expected cash flows
have higher average
returns that are not captured by the three-factor model or the
CAPM. The authors
interpret their results as evidence that stock prices are
irrational, in the sense that
they do not reflect available information about expected
profitability.
In truth, however, one can’t tell whether the problem is bad
pricing or a bad
asset pricing model. A stock’s price can always be expressed as
the present value of
expected future cash flows discounted at the expected return on
the stock (Camp-
bell and Shiller, 1989; Vuolteenaho, 2002). It follows that if
two stocks have the
same price, the one with higher expected cash flows must have a
higher expected
return. This holds true whether pricing is rational or irrational.
Thus, when one
observes a positive relation between expected cash flows and
expected returns that
is left unexplained by the CAPM or the three-factor model, one
can’t tell whether
it is the result of irrational pricing or a misspecified asset
pricing model.
The Market Proxy Problem
Roll (1977) argues that the CAPM has never been tested and
probably never
will be. The problem is that the market portfolio at the heart of
the model is

theoretically and empirically elusive. It is not theoretically
clear which assets (for
example, human capital) can legitimately be excluded from the
market portfolio,
and data availability substantially limits the assets that are
included. As a result, tests
of the CAPM are forced to use proxies for the market portfolio,
in effect testing
whether the proxies are on the minimum variance frontier. Roll
argues that
because the tests use proxies, not the true market portfolio, we
learn nothing about
the CAPM.
We are more pragmatic. The relation between expected return
and market
beta of the CAPM is just the minimum variance condition that
holds in any efficient
portfolio, applied to the market portfolio. Thus, if we can find a
market proxy that
is on the minimum variance frontier, it can be used to describe
differences in
expected returns, and we would be happy to use it for this
purpose. The strong
rejections of the CAPM described above, however, say that
researchers have not
uncovered a reasonable market proxy that is close to the
minimum variance
frontier. If researchers are constrained to reasonable proxies, we
doubt they
ever will.
Our pessimism is fueled by several empirical results.
Stambaugh (1982) tests
the CAPM using a range of market portfolios that include, in
addition to U.S.

common stocks, corporate and government bonds, preferred
stocks, real estate and
other consumer durables. He finds that tests of the CAPM are
not sensitive to
expanding the market proxy beyond common stocks, basically
because the volatility
of expanded market returns is dominated by the volatility of
stock returns.
One need not be convinced by Stambaugh’s (1982) results since
his market
proxies are limited to U.S. assets. If international capital
markets are open and asset
prices conform to an international version of the CAPM, the
market portfolio
should include international assets. Fama and French (1998)
find, however, that
betas for a global stock market portfolio cannot explain the high
average returns
observed around the world on stocks with high book-to-market
or high earnings-
price ratios.
A major problem for the CAPM is that portfolios formed by
sorting stocks on
price ratios produce a wide range of average returns, but the
average returns are
not positively related to market betas (Lakonishok, Shleifer and
Vishny, 1994; Fama
and French, 1996, 1998). The problem is illustrated in Figure 3,
which shows

average returns and betas (calculated with respect to the CRSP
value-weight port-
folio of NYSE, AMEX and NASDAQ stocks) for July 1963 to
December 2003 for ten
portfolios of U.S. stocks formed annually on sorted values of
the book-to-market
equity ratio (B/M).6
Average returns on the B/M portfolios increase almost
monotonically, from
10.1 percent per year for the lowest B/M group (portfolio 1) to
an impressive
16.7 percent for the highest (portfolio 10). But the positive
relation between beta
and average return predicted by the CAPM is notably absent.
For example, the
portfolio with the lowest book-to-market ratio has the highest
beta but the lowest
average return. The estimated beta for the portfolio with the
highest book-to-
market ratio and the highest average return is only 0.98. With
an average annual-
ized value of the riskfree interest rate, Rf , of 5.8 percent and an
average annualized
market premium, RM � Rf , of 11.3 percent, the Sharpe-Lintner
CAPM predicts an
average return of 11.8 percent for the lowest B/M portfolio and
11.2 percent for
the highest, far from the observed values, 10.1 and 16.7 percent.
For the Sharpe-
Lintner model to “work” on these portfolios, their market betas
must change
dramatically, from 1.09 to 0.78 for the lowest B/M portfolio and
from 0.98 to 1.98
for the highest. We judge it unlikely that alternative proxies for
the market

portfolio will produce betas and a market premium that can
explain the average
returns on these portfolios.
It is always possible that researchers will redeem the CAPM by
finding a
reasonable proxy for the market portfolio that is on the
minimum variance frontier.
We emphasize, however, that this possibility cannot be used to
justify the way the
CAPM is currently applied. The problem is that applications
typically use the same
6 Stock return data are from CRSP, and book equity data are
from Compustat and the Moody’s
Industrials, Transportation, Utilities and Financials manuals.
Stocks are allocated to ten portfolios at the
end of June of each year t (1963 to 2003) using the ratio of
book equity for the fiscal year ending in
calendar year t � 1, divided by market equity at the end of
December of t � 1. Book equity is the book
value of stockholders’ equity, plus balance sheet deferred taxes
and investment tax credit (if available),
minus the book value of preferred stock. Depending on
availability, we use the redemption, liquidation
or par value (in that order) to estimate the book value of
preferred stock. Stockholders’ equity is the
value reported by Moody’s or Compustat, if it is available. If
not, we measure stockholders’ equity as the
book value of common equity plus the par value of preferred
stock or the book value of assets minus
total liabilities (in that order). The portfolios for year t include
NYSE (1963–2003), AMEX (1963–2003)
and NASDAQ (1972–2003) stocks with positive book equity in t
� 1 and market equity (from CRSP) for
December of t � 1 and June of t. The portfolios exclude

securities CRSP does not classify as ordinary
common equity. The breakpoints for year t use only securities
that are on the NYSE in June of year t.
market proxies, like the value-weight portfolio of U.S. stocks,
that lead to rejections
of the model in empirical tests. The contradictions of the CAPM
observed when
such proxies are used in tests of the model show up as bad
estimates of expected
returns in applications; for example, estimates of the cost of
equity capital that are
too low (relative to historical average returns) for small stocks
and for stocks with
high book-to-market equity ratios. In short, if a market proxy
does not work in tests
of the CAPM, it does not work in applications.
Conclusions
The version of the CAPM developed by Sharpe (1964) and
Lintner (1965) has
never been an empirical success. In the early empirical work,
the Black (1972)
version of the model, which can accommodate a flatter tradeoff
of average return
for market beta, has some success. But in the late 1970s,
research begins to uncover
variables like size, various price ratios and momentum that add
to the explanation
of average returns provided by beta. The problems are serious
enough to invalidate

most applications of the CAPM.
For example, finance textbooks often recommend using the
Sharpe-Lintner
CAPM risk-return relation to estimate the cost of equity capital.
The prescription is
to estimate a stock’s market beta and combine it with the risk-
free interest rate and
the average market risk premium to produce an estimate of the
cost of equity. The
typical market portfolio in these exercises includes just U.S.
common stocks. But
empirical work, old and new, tells us that the relation between
beta and average
return is flatter than predicted by the Sharpe-Lintner version of
the CAPM. As a
Figure 3
Average Annualized Monthly Return versus Beta for Value
Weight Portfolios
Formed on B/M, 1963–2003
Average returns
predicted by
the CAPM
0.7
9
10
11
12
13

14
15
16
17
0.8
10 (highest B/M)
9
6
3
2
1 (lowest B/M)
5
4
7
8
0.9 1 1.1 1.2
A
ve
ra
ge

a
n
n
u
al
iz
ed
m
o
n
th
ly
r
et
u
rn
(
%
)
result, CAPM estimates of the cost of equity for high beta
stocks are too high
(relative to historical average returns) and estimates for low

beta stocks are too low
(Friend and Blume, 1970). Similarly, if the high average returns
on value stocks
(with high book-to-market ratios) imply high expected returns,
CAPM cost of
equity estimates for such stocks are too low.7
The CAPM is also often used to measure the performance of
mutual funds and
other managed portfolios. The approach, dating to Jensen
(1968), is to estimate
the CAPM time-series regression for a portfolio and use the
intercept (Jensen’s
alpha) to measure abnormal performance. The problem is that,
because of the
empirical failings of the CAPM, even passively managed stock
portfolios produce
abnormal returns if their investment strategies involve tilts
toward CAPM problems
(Elton, Gruber, Das and Hlavka, 1993). For example, funds that
concentrate on low
beta stocks, small stocks or value stocks will tend to produce
positive abnormal
returns relative to the predictions of the Sharpe-Lintner CAPM,
even when the
fund managers have no special talent for picking winners.
The CAPM, like Markowitz’s (1952, 1959) portfolio model on
which it is built,
is nevertheless a theoretical tour de force. We continue to teach
the CAPM as an
introduction to the fundamental concepts of portfolio theory and
asset pricing, to
be built on by more complicated models like Merton’s (1973)
ICAPM. But we also
warn students that despite its seductive simplicity, the CAPM’s

empirical problems
probably invalidate its use in applications.
y We gratefully acknowledge the comments of John Cochrane,
George Constantinides, Richard
Leftwich, Andrei Shleifer, René Stulz and Timothy Taylor.
7 The problems are compounded by the large standard errors of
estimates of the market premium and
of betas for individual stocks, which probably suffice to make
CAPM estimates of the cost of equity rather
meaningless, even if the CAPM holds (Fama and French, 1997;
Pastor and Stambaugh, 1999). For
example, using the U.S. Treasury bill rate as the risk-free
interest rate and the CRSP value-weight
portfolio of publicly traded U.S. common stocks, the average
value of the equity premium RMt � Rft for
1927–2003 is 8.3 percent per year, with a standard error of 2.4
percent. The two standard error range
thus runs from 3.5 percent to 13.1 percent, which is sufficient to
make most projects appear either
profitable or unprofitable. This problem is, however, hardly
special to the CAPM. For example, expected
returns in all versions of Merton’s (1973) ICAPM include a
market beta and the expected market
premium. Also, as noted earlier the expected values of the size
and book-to-market premiums in the
Fama-French three-factor model are also estimated with
substantial error.
References

Ball, Ray. 1978. “Anomalies in Relationships
Between Securities’ Yields and Yield-Surrogates.”
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