How the Inflation Illusion Killed the CAPM

What killed the CAPM? While there may not be enough evidence to pronounce a court sentence, a leading candidate is the inflation illusion. Cohen, Polk, and Vuolteenaho “show that an implication of this joint hypothesis is that the security market line (the relation between an asset’s average return and its CAPM beta) is steeper [i.e there is a larger risk premium] than predicted by the Sharpe-Lintner CAPM when inflation is low or negative. Conversely, when inflation is high, the security market line is shallower [i.e. there is a smaller risk premium] than the Sharpe-Lintner CAPM’s prediction.” Another MUST read!
[FinanceProfessor.com Annotation]

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