A two‐pass model study of the CAPM: evidence from the UK stock market

Purpose There has been considerable debate on the linear relationship between systematic risk and return. The purpose of this study is to investigate whether security return can be explained by systematic risk. Design/methodology/approach This study employs the market model to test the effect of excess return on portfolio returns. The paper divides total risk into systematic and idiosyncratic risk to examine whether the degree of inefficient portfolio diversification impairs the applicability of the capital asset pricing model (CAPM). In the two‐pass cross‐sectional regressions, the paper assesses whether excess return on a security is directly proportional to the security's beta. The paper also incorporates the total variance of securities and the squared value of beta to capture idiosyncratic risk and the nonlinear risk‐return relationship. Findings The CAPM is rejected due to positive intercepts in most portfolios and there are large proportions of idiosyncratic risk in these portfolios. Two‐pass regressions show that the security market line theory is valid when additional variables are included in the equation. However, survivorship bias appears to be present in the selected sample. Practical implications Since large excess returns are present in the models, the traditional CAPM is rejected and incomplete portfolio diversification can be explained by high levels of idiosyncratic risk. Originality/value The authors find that inefficient portfolio diversification is due to the level of idiosyncratic risk in a portfolio. Evidence of the nonlinear beta‐return relationship suggests that the traditional CAPM is misspecified.