Arbitrary CAPM

By Felix Salmon
January 29, 2010
Emanuel Derman passes on an email from a former student, who's now working at ****:

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Emanuel Derman passes on an email from a former student, who’s now working at ****:

Will Sharpe came up with his Capital Asset Pricing Model (which we use at **** all the time, in its most simplistic form) and now it is part of the dogma that asset returns are linearly related to market returns. What is the logical basis to assume a linear relationship here? He could have just as easily assumed a cubic relationship (which will almost by definition fit past data better) and done the same work. His math would have probably gotten messier, but it is hard to find any merits to the linear assumption other than the fact that it is simple. I am all for simplicity, and perhaps if I asked Sharpe he’d tell me that was just a reasonable first approximation, but that is certainly not the way in which people use it now (maybe they are not so rational after all?).

The fact is that **** could be pretty much any buy-side or sell-side firm in the world. And so long as they all talk about concepts like “alpha” in more or less the same way, as though it’s a real scientific thing, in a way it doesn’t matter whether it’s based on empirically-justifiable principles or not. Still, this is a useful reminder that when finance types start blinding you with science, it’s not science in the sense of actually reflecting reality. At best it’s a useful fictional construct, at worst it can help cause a global economic meltdown.

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