The CAPM with Endogenous Beliefs

Abstract

The CAPM is one of the basic models in finance, combining one-period ahead exogenously given (rational) expectations and mean-variance preferences. This combination results in implications that are heavily criticized, both empirically and theoretically, resulting in a rejection of mean-variance preferences. In this paper we consider the CAPM as an equilibrium model of interacting mean-variance investors where the investors' beliefs are not assumed to be given exogenously, but are determined endogenously, as part of the CAPM equilibrium. We postulate that according to these beliefs arbitrage opportunities are excluded and that these beliefs are rational, i.e., in line with the CAPM equilibrium, so that the standard way of testing the CAPM no longer applies. Instead, we derive clear one-period ahead predictions. When confronting such predictions with actual data, the one-factor CAPM performs quite well, much better than the traditional, alternative multi-factor models, when the comparable predictions according to these models are confronted with actual data.