Capital Asset Pricing Model (Capm)

2553 Words Jul 10th, 2011 11 Pages
Introduction

Capital asset pricing has always been an active area in the finance literature. Capital Asset Pricing Model (CAPM) is one of the economic models used to determine the market price for risk and the appropriate measure of risk for a single asset. The CAPM shows that the equilibrium rates of return on all risky assets are function of their covariance with the market portfolio. This theory helps us understand why expected returns change through time. Furthermore, this model is developed in a hypothetical world with many assumptions.

The Sharp-Lintner-Black CAPM states that the expected return of any capital asset is proportional to its systematic risk measured by the beta. (Iqbal and Brooks, 2007). Based on some simplifying
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This creates a new line, the security market line (SML). The SML can be used to determine an asset’s expected return, given its beta. According to the formula, the portfolio’s expected return equals the rate earned on risk-free assets plus the amount of risk taken (measured by beta) times the market risk premium.

In the CAPM, betas are generally estimated from the stock’s characteristic line by running a linear regression between past returns on the stock in question and past returns on some market index. Bringham and Ehrhardt (2005) define betas developed in this manner as historical betas. However, Fama and French (1992) argue about the reliability of beta in explaining the differences in expected returns. According to their studies, they have found empirical evidence that firm size, book-to-market, and earnings-to-price have significant explanatory power for average returns, calling into question the descriptive validity of the CAPM of Sharpe (1964), Lintner (1965), and Black (1972). The validity of the CAPM is questioned because of the CAPM posits a positive linear relation between ex ante expected returns and betas, while other firm specific variables such as firm size, book-to-market, and earnings-to-price should not have any ability to explain average cross-sectional returns. The empirical evidence of Fama and French thus contradicts the CAPM.

The Fama and French study…