Asset Pricing and Excess Returns Over the Market Return

Abstract

Under the APT framework and the assumption that the market portfolio is well-diversified, if not mean-variance efficient, the common factors in raw-returns are the market return plus the common factors in the space of excess-returns over the market return. This explains why the market betas fail to explain the cross-section of expected returns in multi-factor models. Market betas cannot price assets because either they are under-identified or become unitary. However, the market portfolio is still useful for asset pricing because the empirical relevance of a multi-factor model can be tested by using excess-returns over the market return.