Critical Analysis of the Relative Merits of the Capital Asset Pricing Model (Capm) and the Fama and French (F&F) Three-Factor Model (Tfm)

Here we choose VW NYSE, AMEX, and NASDAQ data as market returns, because it’s value weighted and more reliable. The results show CSC’s equity beta = 2.27, QRG’s equity beta = 1.79.

‘The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the industry even though it is based on very strong assumptions. Discuss in the light of recent developments in the area.’

For estimation of betas, the above equation was run for the period from Jan, 2003 to Dec, 2006. Based on the estimated betas we have divided the sample of 63 stocks into 10 portfolios each comprising of 6 stocks except portfolio no.1, 5 and 10 having seven stocks each. The first portfolio 1 has the 7 lowest beta stocks and the last portfolio 10 has the 7 highest beta stocks. The rationale for forming portfolios is to reduce measurement error in the betas.

The analysis of this paper will derive the validity of the Fama and French (FF) model and the efficiency of the Capital Asset Pricing Model (CAPM). The comparison of the Fama and French Model and CAPM (Sharpe, 1964 & Lintner, 1965) uses real time data of stock market to practise its efficacy. The implication of the function in realistic conditions would justify the utility of the CAPM theory. The theory suggests that the expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the expected return on the market portfolio, the variance of the return on the market portfolio, and

Still, the CAPM serves as a useful theoretical framework for understanding risk and leads naturally to multiple factor models and the arbitrage pricing theory described in Appendix B to this chapter.

3. The main message of the capital asset pricing model is that risk and return are related. Under CAPM, the expected return of an asset is directly correlated to the beta, so the higher the beta the higher the expected return of the asset. This is the risk-return relationship. Under CAPM, an investor cannot "beat" the market on a risk-adjusted basis. To corporations, the principle is the same. CAPM is a way to calculate the cost of equity, but again the cost of equity is related to the volatility of the firm's stock price, and therefore a company with a more volatile stock price is one that will have

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.

Figure 1 outlines seven commonly discussed factor exposures that are notable both for the extensive literature documenting each, and for the empirical evidence of historical positive risk-adjusted excess returns associated with them. We do not attempt to exhaustively analyze these factors; rather, we briefly emphasize relevant aspects for investors to consider in evaluating the factor-based approach. Two points should be mentioned at the outset: First, investors may knowingly or unwittingly already hold certain factor exposures within their portfolios. For example, a portfolio of stocks with low price/earnings ratios is likely to have exposure to the "value" factor. Second, the investment case for some factors is subject to ongoing debate- namely, whether past observed excess risk-adjusted returns will continue going forward.

Capital market has deep developed this century, more and more investors go into this market. Which security is better? How to invest? Investors need numeric index to make decision. There are some theories to help investors: portfolio theory, capital asset pricing model (CAPM), option pricing model and so on. This essay will explain portfolio theory firstly. Secondly, this essay will explain CAPM and discuss the importance of the assumptions of CAPM. Thirdly, this essay will explain arbitrage pricing theory (APT) and factors model. Finally, this essay will compare CAPM with APT and factors model.

There are many different asset pricing and portfolio management models available to assist us in the estimation and evaluation of a stock’s return. The Fama-French Model (“FFM”) is one of those models. Kenneth French and Eugene Fama who were professors at the University of Chicago Booth School of Business designed the FFM. Kenneth French and Eugene Fama observed that historically, the Capital Asset Pricing Model (“CAPM”), which was predominantly used, was inaccurate as it often resulted in high alpha values which meant that a huge portion of excess returns were left unexplained. They also observed that companies with smaller market caps would outperform companies with higher market caps and companies with higher book-to-market (“B/E”)

The Capital Asset Pricing Model (CAPM), was first developed by William Sharpe (1964), and later extended and clarified by John Lintner (1965) and Fischer Black (1972). Four decades after the birth of this model, CAPM is still accepted as an appropriate technique for evaluating financial assets and retains an important place in both academic scholars and finance practitioners. It is used to estimate cost of capital for firms, evaluating the performance of managed portfolios and also to determine asset prices. Since the inception of this model there have been numerous researches and empirical testing to assess the strength and the validity of the model.

Capital Asset Pricing Model (CAPM) was developed in 1964 based on Modern Portfolio Theory. CAMP widely used in investment decisions and financial areas of the company. The main research of CAMP are the relationship between expected rate of return and risk assets in the stock market, as well as how the equilibrium price formation. In terms of the valuation of assets, CAPM primarily used to determine whether the securities market be mispricing. Capital Asset Pricing Model measure risk by non-diversified variance, it linked risk and expected return, any non-diversified risk assets can be described by the value of β, then calculate the expected rate of return. Rate of return

This paper looks at The Capital Asset Pricing Model (CAPM) and how it can be used by fund

This essay will illustrate the practicability of the capital asset pricing model (the CAPM). Before 30 years ago, the capital asset pricing model was a significant development. This theoretical model has been used in many large companies. Yet, many economists argue that this model has its own drawbacks. In 1992, Fama and French said that the application of CAPM could be useless which against empirical tests of the CAPM. For instance, the CAPM was seen as an obsolete theory because of the limitation of its assumptions. Main assumptions can be categorized into six aspects. First, the CAPM assumption was built on that the capital market is always in equilibrium. This assumption is difficult to achieve in the real world. Second, there are a numeral of investors who hold the same period of their asset in the market and no considering of the outcome after the investment plan. However, there are too many investors in the market, it is impossible that their time of holding the asset could be exactly the same. Therefore, the second assumption is also unachievable. The third hypothesis is that investors have unrestricted of borrowing and lending at fixed risk-free rate which is also very difficult. The fourth of assumption is assumed that there are no transaction costs and taxes. But in fact, these factors are all existed in the real market. Then, the fifth and sixth assumption shows all investors have the same expectation on their investment portfolio. Obviously, these two

This study explores the (troubling) empirical evidence bearing on capital asset pricing theories. General formulas for the coefficient on beta and it standard error are derived, which show that the outcomes of cross-sectional tests have no causal relation to the pricing models. If a test refutes a model, this could be because the model is misspecified or because poor proxies for true expected returns and betas are used. Simulation and calibration results suggest that realized returns are a much poorer proxy than estimated betas are. The noise in realized returns typically inflates the estimated standard error, with drastic effects on the statistical power. Inferences based on ex ante returns are more powerful but suffer from a serious size problem. JEL: G12, C31, C52.