The Mathematics of Financial Modelingand Investment Management

17-Capital Asset Pricing Model Page 525 Wednesday, February 4, 2004 1:10 PM

Capital Asset Pricing Model 525

the characteristic line measures the return relative to the risk-free rate in

each period. In the case of the characteristic line, a proxy for the market

portfolio is used. This is in contrast to the market model where the

index need not be the market portfolio.

This distinction between the beta in the market model and the beta

in the characteristic line is important. As we will see in the next section,

critics of portfolio selection and the CAPM have incorrectly made state-

ments about the drawbacks of these theories because they fail to under-

stand the distinction between these two betas. Adding to the confusion

was that Sharpe introduced both of these beta concepts around the same

time (1963 and 1964).

THE ROLE OF THE CAPM IN INVESTMENT MANAGEMENT

APPLICATIONS

In 1980, a highly regarded magazine published an article with the title

“Is Beta Dead?”^19 In response to this article, in its Winter 1981 issue

The Journal of Portfolio Management published a series of articles. The

article by Barr Rosenberg in particular provides an excellent discussion

of the CAPM and its role.^20

The key to the CAPM’s contribution to investment management the-

ory is clearly stated by Rosenberg:

The CAPM is theory, but, paradoxically, the role of the

CAPM as “theory” leading to application has been less

important than its role in mobilizing attention and defin-

ing constructs. We should keep in mind that the CAPM is

not “true,” since many of its assumptions are not exactly

satisfied in the real world. Indeed, the CAPM rules out

active management and investment research, and thus

abolishes most applications at the stroke of a pen, by vir-

tue of the unrealistic assumptions that it makes. (p. 5)

That is, even though the CAPM is not true it does not mean that the

constructs introduced by the theory are not important. Constructs intro-

duced in the development of the theory include the notion of a market

portfolio, systematic risk, diversifiable risk, and beta. As Rosenberg

(^19) Anise Wallace, “Is Beta Dead?” Institutional Investor (July 1980), pp. 23–30.
(^20) Barr Rosenberg, “The Capital Asset Pricing Model and the Market Model,” The
Journal of Portfolio Management (Winter 1981), pp. 5–16.