An Overview and critique of the capital asset pricing model

Presenter: Sarbajit Chakraborty Discussants: Gabrielle Santos Ken Schultz

Outline

1. Background

2. Theory and Applications

3. Problems

4. Possible Critique

5. Conclusion

background

Introduced independently by William Forsyth

Sharpe in 1964 and John Lintner in 1965.

- Based on earlier works of Harry Markowitz on

Diversification and the Modern Portfolio

Theory(MPT) introduced in 1952.

- In 1990 Markowitz, Sharpe and Merton Miller were

awarded the Nobel Prize in Economic Sciences for

their combined contribution to the field of Financial

Economics

theory and applications

The Capital Asset Pricing Model(CAPM)

essentially states that a market portfolio of

invested wealth is mean-variance efficient

resulting in a linear cross-sectional

relationship between mean excess returns

and exposures to the market factor.

Contd.

To understand the underlying theory of

CAPM we first have to discuss two very

essential concepts related to the theory:

1. The Capital Market Line(CML)

2. The Security Market Line(SML)

The capital market line

The capital market line (CML) specifies the return an individual investor expects to receive on a portfolio. This is a linear relationship between risk and return on efficient portfolios

Security market line

The security market line (SML) expresses the

return an individual investor can expect in

terms of a risk-free rate and the relative risk

of a security or portfolio

where β = Covariance of an individual security/weighted average

of the betas of the component securities of the portfolio

Contd.

Security Market Line

Also follows a liner

relationship between

the Expected return

And Beta

Assumptions

1. The CAPM is an ex-ante, static(one period

model).

2. Assumes that individual investors are

rational and since the model is based on

Markowitz’s MPT, it draws on the assumption

that markets are inherently efficient.

Problems

1. CAPM could not explain why there’s no significant

statistical relationship between the cross section of

average equity returns in the US market to the β’s of

the original CAPM model.

2. CAPM also couldn’t provide a solution as to why

rational investors behave so irrationally when

markets do not act as efficiently as they are

supposed to.

Critique

Fama-French 3 factor model

-  Beta (β) is the most important risk factor but

it only counts for 70% of the actual portfolio

returns

- the size of the stocks in a portfolio &

- the price-to-book value of the stocks made

significant differences

Behavioral finance

The field of “behavioural finance” has

evolved that attempts to better understand

and explain how emotions and cognitive

errors influence investors and the decision-

making process. Kahneman and Tversky

(1979), Shefrin and Statman (1994), Shiller

(1995) and Shleifer (2000) are among the

few to be named.

Behavioral finance

Behavioral finance draws on the experimental evidence of the cognitive psychology and the biases that arise when people form beliefs, preferences and the way in which they make decisions, given their beliefs and preferences (Barberis and Thaler, 2003)

Prospect theory

Daniel Kahneman, Nobel Prize in Economic

Sciences in 2002.

“people place much more weight on the

outcomes that are perceived more certain

than that are considered mere probable, a

feature known as the “certainty effect” (Kahneman,1979)

CAPM &the labor theory of value

Labor search frictions are an important

determinant of the cross-section of equity

returns(Kuehn&Simutin,2013)

As an equilibrium outcome of the labor

market, labor market tightness is negatively

related to labor market participation shocks

Conclusion

The validity of The Capital Asset Pricing Model has been questioned time and again by numerous economists. The model takes in assumption which are “ridiculously wrong”. Still it has been in extensive use for almost half a century because it the model is a first of its kind to give investors a general idea on “risk and return” on an investment or capital budgeting for firms

bibliography

Fama, Eugne, and Kenneth French. “The Cross-Section of Expected Stock Returns.” The Journal of Finance 47, no. 2 (June 1992): 427-65. http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1992.tb04398.x/abstract (accessed March 17, 2013).

 

Kuehn, Lars-Alexander, Mikhail Simutin, and Jesse Wang. “A Labor Capital Asset Pricing Model.”  (February 2013): 1-56.http://financeseminars.darden.virginia.edu/Lists/Calendar/Attachments/167/Paper%20-%20Lars%20Alexander%20Kuehn.pdf (accessed March 17, 2013).

Fama, Eugene, and Kenneth French. “The Capital Asset Pricing Model: Theory and Evidence.” Journal of Economic Perspectives 18, no. 3 (Summer 2004): 25-46. http://www-personal.umich.edu/~kathrynd/JEP.FamaandFrench.pdf (accessed April 7, 2013).

Amos Tversky, Daniel Kahneman. “Prospect Theory: An Analysis of Decision under Risk.” Econometrica47, no. 2 (March 1979): 263-92. http://www.hss.caltech.edu/~camerer/Ec101/ProspectTheory.pdf(accessed April 7, 2013).