Working Paper: NBER ID: w1113
Authors: Jeffrey A. Frankel; William T. Dickens
Abstract: The Capital Asset Pricing Model (CAPH) says that the responsiveness of asset-demands to expected returns depends (inversely) on the variance-covariance matrix of returns, rather than being an arbitrary set of parameters.Previous tests of CAPM have usually computed covariances of returns around sample means, and then checked whether the riskier assets are those with the higher mean returns. We offer a new technique for testing CAPM. The technique requires the use of time series data on actual asset-holdings, and non-linear maximum likelihood estimation. We claim superiority to earlier tests on three grounds. (1) We allow expected returns to vary freely overtime.(2) The alternative hypothesis is well-specified: asset-demands are linear functions of expected returns that do not depend on the variance-covariance matrix.(3) The test-statistic has a known distribution; it is simply a likelihood ratio test. We try the technique on yearly data, 1954-1980, for household holdings of a portfolio of six assets: short-term bills and deposits, tangible assets, federal debt, state and local debt, corporate debt, and equities. Our test rejects the CAPM hypothesis.
Keywords: Capital Asset Pricing Model; Asset Demand; Nonlinear Maximum Likelihood Estimation
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| asset demands (G32) | expected returns (G17) |
| expected returns (G17) | asset demands (G32) |
| CAPM (O22) | asset demands (G32) |
| CAPM (O22) | expected returns (G17) |
| variance-covariance matrix (C10) | asset demands (G32) |
| variance-covariance matrix (C10) | expected returns (G17) |