New Fernandez paper on troubles with financial models, especially CAPM

BVWireIssue #175-2
April 12, 2017

Finance and Financial Economics: A Debate About Common Sense and Illogical Models,” by Pablo Fernandez (University of Navarra, IESE Business School), says that financial economics is a subject developed by economists whose main purpose is to elaborate “models” based on unrealistic assumptions, which makes it very different from finance. These models “have very little to do with the real world: companies, financial markets, investors, managers,” and the “most emblematic example is the CAPM,” he says.

Still absurd: Fernandez wrote the 2014 paper “CAPM: An Absurd Model,” which generated so many comments that he issued a revised version and also published the comments as a separate paper. Over three-quarters (78%) of the commenters agree with the term “absurd” to describe CAPM. In an interview with Business Valuation Update at the time, Fernandez believes the affinity for using models and “recipes” is partly the reason valuation practitioners continue to use CAPM. “For consulting firms and regulators, there's also a lot of inertia and still enough of a mass of firms using it that you can justify its use by showing a list of all of those firms and people who still use it,” he says. “From the point of view of consulting firms, the beta impresses clients and people who are not in finance because it gives a sense of something magical and difficult going on. Also, it's very easy to copy the last valuation your company or colleague did when you are doing a new one, so that can perpetuate it.”

In the new paper, Fernandez says: “We think that common sense, experience and some business and financial knowledge are much better than a bad theory and an absurd model.” He asks readers to comment on his opinions.

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