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Discuss potential explanations for the Security Market Line has been flatter than the Capital Asset Pricing Model (CAPM) would predict.

Student Name: Jiaxin Shen Student Number: 100103708

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Discuss potential explanations for the Security Market Line has been flatter than the Capital Asset Pricing Model (CAPM) would predict.
The Capital Asset Pricing Model is based on asset portfolio theory and capital market theory. It emphasizes on the study of the relation between the expected return of asset and risky asset in the securities market. As one of prediction models based on the balance of risky asset expected return, CAPM elaborates on the formation of market equilibrium in the case of investors through Markowitz’ theory to investment management. (Pennacchi, 2008) It shows that a sample liner relation about expected return of asset and expected risks. In the model, beta is a significant parameter, since it measures the expected risks of assets. The Capital Asset Pricing Model has been widely adopted by investors, however, it has some limitation. The relation between beta and average return is too flat is confirmed in time-series tests. It is described by the the Security Market Line. Black, Jensen and Scholes (1972) concentrated their attention on the security market line. If the portfolio is efficient, which means there is a positive relation between beta and expected return. The study of Fama and MacBeth (1973) mainly focus on predicting the future returns of the portfolio based on the last estimate of the risk variables. However, the evidence of their studies showed that the relation between beta and average return is too flat is confirmed in time-series tests. When beta is low, the intercepts in time-series regressions of excess asset returns is higher than the predicted return in the CAPM model, and beta changes to higher, the intercepts

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