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The Measurement of Returns in Tests of the CAPM

Periodic returns are widely used to estimate expected return when testing the CAPM. We show that in the original one-period CAPM, the linear relationship between beta and the expected periodic return is obtained only by adjusting the expected continuously compounded return, and the linearity is well-preserved as the length of the period is increased. A reasonable interpretation of the empirical evidence is that tests of the CAPM that use periodic returns simply reflect the variance of returns, but not the pricing of securities as required by an asset pricing model.