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IAI Actuarial Core Principles · Economic Modelling · Capital Asset Pricing Model (CAPM)

Roll's critique of empirical tests of the CAPM argues mainly that:

Roll's critique says the CAPM cannot be properly tested unless the true market portfolio, containing every risky asset, is observed. Because it is unobservable, any index used is only a proxy, so tests of the model may accept or reject it wrongly.

  1. ABetas are always unstable over time, so no test can be run
  2. BThe CAPM can only be tested if the true market portfolio, including all risky assets, is observed, which is not possibleCorrect
  3. CInvestors are never risk averse, so the model assumptions fail
  4. DTests must use monthly returns rather than daily returns
  5. The risk-free rate cannot be measured in any market

Explanation

Roll argued that the CAPM's only testable implication is that the true market portfolio is mean-variance efficient. Since the true market portfolio contains all risky assets and is unobservable, a proxy such as an equity index can give misleading results. The other options are not the core of the critique.

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