A Capital Asset Pricing Model with Feedback Effect

This paper aims to develop and test an alternative CAPM model based on the feedback effect to enhance its explanatory power, given the standard theory's limited ability to achieve R-squared values higher than 30%. The joint impact of corporate performance and stock market index returns can explain a significant fraction of the variation in stock returns, suggesting that a feedback effect is in action. We can achieve better results than the CAPM by replacing stock market index returns with the endogenous portfolio returns computed by the model on the selected stocks, leveraging the feedback effect. The results are worse than expected due to certain data limitations. The CAPM model with feedback effect reveals the complexity behind stock risk and return that cannot be simplistically represented through the Beta vector. The entire web of the firms’ business performances becomes apparent, along with the possibility that multiple equilibria can exist in the stock market, leaving room for non-homogeneous expectations among investors. Besides, it overturns the unidirectional causal nexus for the financial market dynamics stated by CAPM.