Notes On Capital Asset Pricing Model

Fama and French’s three factor model attempts to explain the variation of stock prices through a multifactor model that includes a size factor and BE/ME factor in addition to the beta risk factor. Fama-French model essentially extended the CAPM (which breaks up cause of variation of stock price into systematic risk which is non-diversifiable and idiosyncratic risk which is diversifiable) by introducing these two additional factors. Fama and French find that stocks with high beta didn’t have consistently higher returns than stocks with low beta and this indicates that beta was not a useful measure under their model. Their model is based on research findings that sensitivity of movements of the size and BE/ME factor constituted risk, and

• Pros – Warren Buffett differed from conventional thinking by using only the rate of return on the long-term U.S. Treasury bond to discount cash flows. He ignored a risk-premium component of CAPM because he invested in only businesses that have predictable and stable earnings. Thus, There as no risk involved because risk comes from not knowing what you are doing.

With Reference to this statement, describe, discuss and illustrate the principles of portfolio theory. Your essay should include coverage of the Markowitz Efficient Frontier and the Capital Market Line.

Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due

CAPM is a model that describes the relationship between risk and expected return, and the formula itself measures the expected return of the portfolio. Mathematically, when beta is higher, meaning the portfolio has more systematic risk (in comparison to the market portfolio), the formula yields a higher expected return for the portfolio (since it is multiplied by the risk premium and is added to the risk free interest rate). This makes sense because the portfolio needs to

The CAPM is a single factor model because it based on the hypothesis that required rate of return can be predicted using one factor that being systematic risk. It looks at risk and rates of returns, compares then to the stock market providing a usable measure of risk to help investors determine what return they will get for risking their money in an investment. There are a lot of assumptions and drawbacks of CAPM that lead to the conclusion that those investors utilizing this

CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.

‘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.’

To reduce a firm’s specific risk or residual risk a portfolio should have negative covariance or rather it should have no variance at all, for large portfolios however calculating variance requires greater and sophisticated computing power. As such, Index models greatly decrease the computations needed to calculate the optimum portfolio. The use of such Index models also eliminates illogical or rather absurd results. The Single Index model (SIM) and the Capital Asset Pricing Model (CAPM) are such models used to calculate the optimum portfolio.

In order to test the validity of the CAPM, we have applied the two-step testing procedure for asset pricing model as proposed by Fama and Macbeth (1973) in their seminal paper.

According to the CAPM model:R_i=α+βR_m+ε, α represent the abnormal return gained by the portfolio. If the market is efficiency, the α has to be zero.

As indicated by the case study S&P 500 index was use as a measure of the total return for the stock market. Our standard deviation of the total return was used as a one measure of the risk of an individual stock. Also betas for individual stocks are determined by simple linear regression. The variables were: total return for the stock as the dependent variable and independent variable is the total return for the stock. Since the descriptive statistics were a lot, only the necessary data was selected (below table.)

Even though there are flaws in the CAPM for empirical study, the approach of the linearity of expected return and risk is readily relevant. As Fama & French (2004:20) stated “… Markowitz’s portfolio model … is nevertheless a theoretical tour de force.” It could be seen that the study of this paper may possibly justify Fama & French’s study that stated the CAPM is insufficient in interpreting the expected return with respect to risk. This is due to the failure of considering the other market factors that would affect the stock price.

One the creators was William Forsyth Sharpe born June 16, 1934 (age 81) Boston, Massachusetts, U.S is an American economist. He graduated from Riverside Polytechnic High. He is the STANCO 25, he was a professor of Finance, Emeritus at Stanford University 's Graduate school of Business, and the winner of the 1990 Nobel Memorial Prize in Economic Sciences. Sharpe was one of the originators of the capital asset pricing model. He created the Sharpe ratio for risk-adjusted investment performance analysis, and he contributed to the development of the binomial method for the valuation of options, the gradient method for asset allocation optimization, and returns based style analysis for evaluating the style and performance of investment funds.The second creator was Jack Lawrence Treynor was born on February 21 1930 and passed away in May 11, 2016. He was the President of Treynor Capital Management, Palos Verdes Estates, CA. He was a Senior Editor and Advisory Board member of the Journal of Investment Management, he was also a Senior Fellow of the Institute for Quantitative Research in Finance. He was also a editor of the CFA Institute 's Financial Analysts Journal.John Virgil Lintner, Jr. (February 9, 1916 – June 8, 1983) was a professor at the Havard Business school in the 1960s and one of the co-creators (1965a,b) of the capital asset pricing model.

Richard Roll, and University and Auburn, University of Washington, and University of Chicago educated economist, began his career researching the effect of major events of stock prices. This experience likely helped him reach the two conclusions he makes in his 1977 “A Critique Of The Asset Pricing Theory’s Tests”, one of the earliest and most influential arguments against CAPM. In the paper, Roll makes two major claims: that CAPM is actually a redundant equation that just further proves the concept of mean-variance efficiency, and that it is impossible to conclusively prove CAPM. His first claim relates to mean-variance efficiency: the idea that mathematically one must be able to create a portfolio that offers the most return for a given amount of risk. Roll claims that all CAPM is doing is testing a portfolio’s mean variance efficiency, and not actually modeling out projected future returns. The second claim in the paper is that there is not enough data about market returns for CAPM to ever prove conclusive. Even if modern technologies could help alleviate some of the burden of testing market returns for publicly traded equities, there is still no way to account for the returns of less liquid markets, where there is less public information. This means it is impossible for