This is to document email correspondence with Prof. Peter M. DeMarzo (Stanford University, USA) and Ignacio Velez-Pareja (Columbia) with regards to the article by Pablo Fernandez posted at SSRN.com under the title "CAPM: An Absurd Model"

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A Quick Comment (still a draft) on Pablo
Fernandez’s Article “CAPM: An Absurd Model”
Pablo Fernandez (Professor of Finance from IESE Business School, University of Navarra, Spain)
posted a paper “CAPM: An Absurd Model”1
.
1
Downloadable from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2505597 with a draft dated
November 19, 2015. This paper was also published in Business Valuation Review, Volume 34, issue 1
(Spring 2015), pages 4-23. The first draft of that paper received many interesting comments, criticism and
suggestions that were later collected in “CAPM: The Model and 305 Comments About It” (downloadable
at http://ssrn.com/abstract=2523870).
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Karnen:
Upon reading that paper, I sent it via an email to Prof. Peter M. DeMarzo (Mizuho Financial Group
Professor of Finance, Stanford Graduate School of Business, USA).
He gave his comments:2
This article is absurd :
CAPM is just a tool, and can be easily misused/abused, just like any other tool (including NPV).
That is why it is important to understand it conceptually, not simply mechanically, so one can
make informed judgments.
Karnen:
In December 2015, I read again the latest draft of that paper (19 November 2015) and other Prof.
Pablo Fernandez’s paper “Huge Dispersion of the Risk-Free Rate and Market Risk Premium
Used by Analysts in USA and Europe in 2015”3
, subsequently, I sent the latest paper to Ignacio
Velez-Pareja (IVP) to get his views.
IVP, instead, replied giving his views on Prof. Pablo Fernandez’s paper “CAPM: An Absurd
Model”.
IVP:
I met Pablo again on Nov 26-27 [2015] at Bogotá [Columbia]. He has lots of evidence about how
CAPM doesn't work. I heard his lecture on that and somehow, I agree with him. As you know, I
think it is OK to ask the investor for the minimum Ke he would accept and calculate the implicit
beta just in case I have to discuss with someone that trusts betas.
Karnen: [in responding to IVP’s email]
2
Via email on 16 October 2014.
3
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2684740

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What I could say, Prof. Pablo is a bit strange in the way he “judges” CAPM and to my surprise,
knowing that he comes from finance background and does a lot of researches in financial markets,
he really misunderstands CAPM.
To my knowledge, CAPM is a “generic” model. It gave us a hint, a clue, an idea (whatever you
want to call it, a better expression, a base rate, a starting point to ask for the required rate) about
the expected rate. Sharpe (Lintner, Mossin, Treynor) built its asset pricing model from an
assumption that all risks (that matter MOST to the investors) “squeezed” into one factor, that is
market and individual security beta. Other finance scholars come up with more than one factor,
APT, Fama-French, etc. This simplifies many things, at least, because it is just a model to give
the idea about where to start when you are asking for your expected rate.
Then if we go to the market, and we can’t find it, since it DOESN’T EXIST in the market. Yes, IT
SHOULD NOT EXIST IN THE MARKET. Why?
Prof. Pablo lasered the attack heavily on the fact that there is no such (and it is not possible to
have) thing called “homogenous” expectation among millions of investors on earth. Yes, he is
correct on that, but that supposed to be that way, if we want to build ONE THEORY for ALL
INVESTORS. Of course, this is not perfect [and it is not possible as well]. The essence of all these
stuffs is we should admit, WE CAN’T PREDICT WHAT’S BASICALLY UNPREDICTABLE (quoted
from Eugene Fama). And we will be very foolish if we really want to have one theory that could
explain everything in this very complicated financial world and markets. Yet, CAPM enriches our
understanding about [the trade-off of ] risk and return, and how the relationship between risk-
return will give us a “better” idea to make an informed judgment. It means, for SOME PRACTICAL
PURPOSES, CAPM can’t be blamed of not giving us an accurate expected return. We are too
foolish if we think CAPM is THE ONLY APPROACH in asset pricing.
Financial market, though full of numbers and figures, but, it is anyway, a centre of capitalism, and
the greater drivers behind the success of capitalism are INDIVIDUAL JUDGMENT and
INITIATIVE. Even if such “homogenous” expectation EXISTS, as a human, we WILL ALWAYS
DIVERT FROM THAT. We don’t want to be homogenous. Financial markets CAN ONLY function
if they consist of many market participants with DIFFERENT (OR HETEROGENOUS) IDEAS
AND EXPECTATIONS about the future. And of course, this very same system and markets will
totally stop when the market participants think the same thing.

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Corporate management and individuals will only be willing to enter into transactions if both
transacting parties HAVE NO THE SAME EXPECTATIONS ABOUT UNCERTAIN FUTURE
EVENTS. Everybody expects that the outcome of the transactions will place the individual or
company in a financial position that “may be” better than expected, yet, it is NOT POSSIBLE TO
confirm that until the uncertainties get resolved. It means, all transacting parties are at risk at
entering a transaction. But this is EXACTLY the force driving the creation of the price (or pushing
the price to their fundamental value).
Modeling “heterogenous” expectation is still a utopia, and I don’t believe we could someday come
up with such model. This is impossible!
I guess, you are quite aware of what Amos Tversky and Daniel Kahneman4
had argued about.
The real-world decision makers didn’t follow the statistical model (note: I believe, some attributes
of statistical model still could be found in the behavior of the decision-makers). Instead, the
decision-makers in many instances, will jump to use simple heuristics (read: rules of thumb).
I guess, it is just wasting our time if we really want to see whether CAPM works in real world. After
I read Richard Roll “A Critique of the Asset Pricing Theory’s Tests: Part I” (1977), that is
impossible to test CAPM5
.
We should fool ourselves if we are to use CAPM as a SINGLE (and the ONLY) model to ask for
our expected return. CAPM + Other Asset Pricing Models + Common Sense + Experience +
Research +…+…. are much better if we want to trust our money into somebody’s hands.
At the end of the day, I will not reject using CAPM.
IVP:
What you have written in this message might be a nice reply to Pablo. Post it at SSRN!
4
Kahneman, Daniel; and Amos Tversky. Prospect Theory: An Analysis of Decision under Risk.
Econometrica (March 1979): 263-92.
5
It has been argued that the CAPM is virtually impossible to test because (a) the only testable hypothesis
of the CAPM is that the “true” market portfolio lies on the efficient set (when this happens, securities’
expected returns and betas have a positive linear relationship) and (b) the “true” market portfolio cannot be
meaningfully measured.
Roll, Richard. A Critique of the Asset Pricing Theory’s Tests: Part I. On Past and Potential Testability
of the Theory. Journal of Financial Economics 4, no. 2 (March 1977): 129-176.

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Listen, the idea of CAPM is basic. WHat it does is to recognize that any interest rate has three
components: inflation, real interest rate and risk (i_c = (1+inf)(1+real rate) -1 + risk premium).
The real problem is to asses the risk premium. And that is a personal issue as we have discussed
these days.
In addition, CAPM is a nice mechanism to estimate that risk component.for an unknown person
(say, the investors in a corporation traded in the market). However, if you have a contact with the
investor (say, in a non-traded firm) and you can talk to him/her and find out some estimate of
his/her risk attitude and risk premium, you could stay out of using the CAPM to measure it. You
might test with known betas such as Damodaran about how far or how close is that estimation
from other estimates that use CAPM. Follow?
What I do in those cases is to test the investor and try to get the lowest discount rate he/she might
accept and I use the CAPM in reverse. This is, which would be the implied beta in his/her
subjective measurement of risk (discount rate) and compare both. Another check one could do
having the investor(s) seated across the table is if they are subject or not of total risk; this is, if
they are or are not diverisfied.
The basic belief behind this approach is that subjectivity should not be dismissed as something
arbitrary. I distinguish between subjectivity and arbitrariness. Subjectivity comes from knowledge
acquired in different ways, experience, hunches, smeel, etc. Arbitrarines comes from nothng. If I
say that the price of oil is going to be X in 2 months and even if I hit the price by the million of a
cent, my estimation is absolutely arbitrary and has no value. However, if someone that works in
oil industry makes a different estimate and obviously doesn't match the price, THAT estimate is
better (a priori, of course) than mine that have no idea of what the price could be. Follow?
In short, I trust subjectivity. The problem is how to dig out a magic number from some experienced
decision maker.
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Reading:
Sharpe, William F.; Gordon J. Alexander; and Jeffery V. Bailey. Investments. Sixth Edition. New
Jersey (USA): Prentice Hall, Inc. 1999.

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