Capital asset pricing model (CAPM) is regarded as a superior model of security price behavior to others based on wealth maximization criteria. CAPM explicitly identifies the risk associated with an ordinary share as well as the future returns it is expected to generate. Until recent the empirical tests supported CAPM, but a test by Fama and French in 1992 did not, stating that it is useless for the precisely what it was developed for. Following the criticism of the model questions such as whether to abandon the model and develop a new one arose. In this essay I will describe the model and describe the researchers test, which justify the usefulness of the model.
Main concepts behind the problem and discussion
The CAPM was developed by Sharpe (1963) as a logical extension to the basic portfolio theory, followed by numerous academics, notably Lintner (1965). The model was developed to explain the difference in risk premium across assets. According to the model this differences are due to the differences in the riskiness of the expected returns. The model affirmers that the correct measure of risk is beta and that the risk premium of riskiness is same across all assets. Given the beta and the risk free rate, the model predicts the expected risk premium. There are several assumptions made. 1) The CAPM is a single-period model, which means that all investors make same decisions over the same period of time and thus expected returns arise from expectations over same period. 2) The CAPM is defined by random variables that are normally distributed, characterized by mean expected returns and covariance’s upon which all investors agree. 3) The CAPM is single index model as systematic risk is predicted entirely by beta factor. Further assumptions are made through Markowitz mean-variance efficiency criteria, based on perfect markets. •All investor are rational and risk averse
•All investments are infinitely divisible.
•All investors are price takers.
•All investors can borrow-lend without restrictions, at the risk-free rate. •Transaction costs are zero.
•All information is available and costless.
When the CAPM assumptions are satisfied, everyone in the economy will hold all risky assets in the same proportion. Thus the betas will be equal for everyone. Therefor the model predicts that the ratio of the risk premium to the beta of every asset is the same. More precisely, every investment provides the same compensation for a given level of risk, when beta is used as a measure of risk. The model had been supported for three decades by many notorious researchers; until in the first half of 1990’s the criticism and doubts in usefulness of the model arose. Critics of the model maintain that its assumptions are so restrictive as to invalidate its conclusions, such as investor rationality, perfect markets and linearity. Furthermore, the model is single period model, based on the estimates, which are difficult to be determined in practice. Moreover, it assumes that investors will hold a well-diversified portfolio that ignores unsystematic risk. Even though there is evidence by Black (1993) that suggests that the CAPM does not work accurately for investments with very high and low betas, most tests validate the CAPM for a broad spectrum of beta values. As the expected returns and betas are unknown, in order to use them in empirical tests researchers had to estimate them. Black, Jensen and Scholes (1972) came up with a clever idea to create portfolios with estimated betas based on historical data. This foresaw grouping assets into portfolios with increasing historical betas, hold the portfolio for several years, and change the portfolio periodically. They analyzed the NYSE over 35 year period by dividing the listing into 10 portfolios. Their study revealed an almost straight-line relationship between portfolio’s beta and its average return. A very important point suggested by these three researchers is...