Explanations for the Volatility Effect: An Overview
Based on the CAPM Assumptions

Abstract

The capital asset pricing model (CAPM) predicts a positive relation between risk and return, but empirical studies find that the actual relation is flat, or even negative. This article provides a broad overview of explanations for this volatility effect and categorizes each explanation according to the CAPM assumption to which it relates. Various explanations relate to investor behavior that is rational, given exogenous incentive structures or constraints, which may explain why the volatility effect has been so persistent over time. The authors argue that, although the CAPM may be bad at explaining reality, addressing the reasons for its failure could actually be a normative arbitrage opportunity.