The Relative Asset Pricing Model: Towards a Unified Theory of Asset Pricing

Abstract

Ever since the development of Modern Portfolio Theory or MPT (essentially Mean-Variance Optimization and the Capital Asset Pricing Model) in the late 1950s and early 1960s, numerous competing theories have been offered by academics. The simplicity of MPT is appealing as the expected return on an asset is simply a function of the return of the market portfolio and that asset’s beta to the market portfolio. The Arbitrage Pricing Theory (APT) suggests that factors over and above the market portfolio may be relevant and has some validation in empirical tests even though the theory is silent on the specific factors. Prospect Theory or Behavioral Finance (PT) finds that investors do not behave as predicted by MPT and MPT seems to be missing a reference point. A more recent proposal, Adaptive Markets Hypothesis (AMH), while lacking a quantitative theory, suggests that applying the principles of evolution, competition, adaptation, and natural selection to financial interactions may explain some of the observed market phenomena. This paper makes a bold claim that all of these approaches (MPT, APT, PT and AMH) can possibly be captured by a simple paradigm called the Relative Asset Pricing Model (RAPM), which is anchored in how investors behave and act. In this paradigm, at the highest level of application, assets are not invested to maximize wealth, but rather funded status, thereby providing a reference point, liabilities, as desired by PT. At a secondary level, asset management is delegated to agents and they also make relative decisions, but this time relative to sub-components of the liability proxy, and with specific constraints because delegation leads to certain challenges. Depending on how liabilities have been proxied in the past, one can show that many of the additional factors postulated in APT (and discovered by Fama-French) can be credibly rationalized under RAPM. Finally, AMH can also be absorbed into this paradigm because as regulations changed over time and as investors got more sophisticated and became creative in delegation, they adapted how they proxied liabilities/structured portfolios thereby explaining certain other phenomena. If the simple model postulated below has all these attributes, it may provide the basis for a Unifying Theory of Asset Pricing, thereby demonstrating that all these current branches of asset pricing are different perspectives of a multi-dimensional RAPM, and that additional research needs to be undertaken to flush out RAPM in more detail and with greater complexity.