Towards Reformulation of The Capital Asset Pricing Model (CAPM) Focusing on Idiosyncratic Risk and Roll's Meta-Analysis: Methodological Approach

Abstract

Understanding idiosyncratic risk represents the next important challenge in the evolution of the Capital Asset Pricing Model [CAPM]. After years of trying to fine tune this simple and elegant model, research is now being focused on the filtered output of the CAPM- the residuals. The reason is simple: the CAPM provides some indicator information but falls far short of explaining, in a predictive sense, asset returns in the trading markets. This then rationalizes the next step that is focused on Knight's concept of uncertainty as this is the model characterization of the residuals of the CAPM. Given the insightful analysis of Roll (1988), where, in terms of R2, the CAPM explains less than 50 per cent of the relative linear movement of the firm's returns relative to those of the market, it is clear that the next analytic issue to be addressed is to sort out the structure of the residuals of the CAPM. This has now resulted in the collection of information that tries to explain or give structure to the uncertainty represented by these residuals. After a summary of the relevant literature where the collection of such information has been reported, we report on the analysis of the corporate social responsibility [CSR] dimension of a firm's market profile. We find that the CSR aspect does indeed provide additional information useful in understanding idiosyncratic risk within the context of the CAPM.

Keywords: Uncertainty, Knight, Ethical screens, Diversifiable risk, Unique risk

JEL Classification: C12, C52, G11, G12, G32