An Economic Analysis of the Competitive Risk-Return Paradigm

Abstract

The Capital Asset Pricing Model (CAPM) is theoretically incomplete in its demand-side focus, risk-averse investors, and internally inconsistent homogeneous beliefs; is not conclusively supported empirically; and yet it legitimizes a notion that investors can earn higher returns by bearing un-diversifiable risk. Our paper does not merely extend the CAPM with more realistic assumptions, it completes its original framework by including (1) risk-taking investors in the investor population, (2) investors who can have heterogeneous expectations or beliefs — an overlooked but required condition for the CAPM to be an internally consistent and meaningful model of competitive financial asset pricing under uncertainty, and (3) a positive-sloped short-run supply curve based on a reasonable interpretation of the nature of financial asset trade. Upon a complete economic interpretation, it is shown the equilibrium (systematic) risk-rate of return relationship depends on whose aggregate trading activity dominates, risk-averse or risk-taking investors’. There is no universal, or even general, positive relationship between systematic risk and rate of return. This has far-reaching implications for investors and investment advisors who serve them.