Rolls Critique - AIM 57.3

[Hardy Noman]

Hi David / Shakti.

Can you please explain the following statements made by Roll (on CAPM)

1) "There is only 1 testable hypothesis associated with the CAPM - the market portfolio is mean variance efficient"
by this does he mean that we are wrongly assuming that the market portfolio lies of the efficient frontier..?

2) "the S&P 500 may not be the proper proxy for the market portfolio. The proxy may be mean-variance efficient, but the market portfolio may not. Many reasonable market proxies may be highly correlated with each other. "
How can a proxy be more efficient than the actual market portfolio, the proxy would surely contain less assets (& asset classes) than the actual market portfolio (which would be the mix of all asset classes and securities in the world)??

Also, please advise on the importance (testability) of this topic.


thanks a ton!
Hardy

 

[ShaktiRathore]

What it means is that As true market portfolio is not observable its impossible to test this assumption of CAPM that the market portfolio is mean variance efficient.So its impossible to decide whether the market portfolio is efficient , hence the critique that this hypothsis of CAPM is still testable , a roll's critique for CAPM.
Secondly the proper proxy is the hypothetical portfolio that represents the actual market portfolio which lies on efficient frontier and yields CAPM, the S&P 500 may not be proper proxy(may be just an approximation) because it does not represent the market exactly as is expected (as all the risky assets classes may not be represented as by true market by it)by one of the assumptions of Capm(see capm assumptions). S&P500 may not represent the entire markets in all its constituents and weights ,asset classes and other assets of true market which are even not traded so its impossible to have an exact proxy for the actual market portfolio.Yes proxy like S&P do not contain all the securities and asset classes that's why this is not be a true proxy for the market.
I dont know about its importance for the exam but the topic is still learnable.
thanks

 

[ShaktiRathore]

also see if this can help:Market efficiency and market equilibrium: An equilibrium model can only exist in the context of market efficiency. Studying market efficiency enables the way in which prices of financial assets evolve towards their equilibrium value to be analysed. Let us first of all define market efficiency and its different forms
... There are several degrees of market efficiency. Efficiency is said to be weak if the information only includes past prices; efficiency is semi-strong if the information also includes public
information; efficiency is strong if all information, public and private, is included in the present prices of assets. Markets tend to respect the weak or semi-strong form of efficiency, but the CAPM’s assumption of perfect markets refers in fact to the strong form.
The demonstration of the CAPM is based on the efficiency of the market portfolio at equilibrium. This efficiency is a consequence of the assumption that all investors make the same forecasts concerning the assets. They all construct the same efficient frontier of risky assets and choose to invest only in the efficient portfolios on this frontier. Since the market is the aggregation of the individual investors’ portfolios, i.e. a set of efficient portfolios, the market portfolio is efficient. In the absence of this assumption of homogeneous investor forecasts, we are no longer assured of the efficiency of the market portfolio, and consequently of the validity of the equilibrium model. The theory of market efficiency is therefore closely linked to that of the CAPM. It is not possible to test the validity of one without the other. This problem constitutes an important point in Roll’s criticism of the model. "
src:http://forum.bionicturtle.com/threads/capm-sml-cml.5347/#post-25440
thanks