Contents

Introduction .................................................................................................................................................. 2
Literature Review .......................................................................................................................................... 3
The Basics of CAPM ................................................................................................................................... 3
The issue of principals and agents ............................................................................................................ 4
New Approaches to CAPM and its alternatives ........................................................................................ 6
Arbitrage Pricing Theory ....................................................................................................................... 6
Fama French Model (Three Factor Model) ........................................................................................... 7
Carhart Model ....................................................................................................................................... 9
Pastor and Stambough Model .............................................................................................................. 9
Illustration and Comparison among the models .................................................................................... 10
Conclusion ................................................................................................................................................... 14
References .................................................................................................................................................. 15
The Existence of CAPM: Is it really dead?

Introduction
The pricing of assets is one of the most important issues relating to financial analysis of
an organization. When an investor in common stock or equity investment, he has to
assume equity risks. Equity risk premium is the incremental or additional return that an
investor seeks to hold the assets. It is the variation between the required return on
equity and the current expected return on risk free assets. One of the most common
ways to determine required return on equity is using CAPM.

The Capital Asset Pricing model (CAPM) was first introduced by Sharpe (1964), Lintner
(1965) and Mossin (1966). Since then it has been a central point of discussion for
financial analysts. According to Graham and Harvey (2001), CAPM is the most effective
model that estimates the cost of equity. However, according to researchers like (Fama
and French, 1992; Strong and Xu, 1997; Jagannathan and Wang, 1996 and Let-tau and
Ludvigson, 2001), CAPM performs poorly for cross-section of return from different
regions. Due to the seemingly poor performance, many researchers have either
declared CAPM as a dead theory, while others have yet again proved that it was not
dead. The Economist, in the time period of 1999-2000 had published a series of articles
that portrayed that CAPM was in a threat from the flow of funds theory and real options
theory. Still no one could nullify the existence of CAPM absolutely.

This piece of work explains CAPM theory and shows why the theory is so charming.
This article then shows simple logics on the validity of the previous tests of CAPM. A
common belief is that CAPM is very simple but its appeal is restricted to only a small
class of investors of the market. But the change of behavior of individuals and pension
system can create a huge impact in its applicability. This piece of work finally shows
some new ways that can create a new possibility for asset pricing.
Literature Review

The Basics of CAPM

According to CAPM, the relation between an asset’s return and risk is as follows,

Where,

= Risk free rate of return

= Expected return on the asset

= the volatility of the asset’s return with the return of the market/ Beta

= Risk premium of equity

The Capital Asset pricing model is the market equilibrium model that estimates the
required return of assets as a linear function of its systematic risk measured by asset’s
beta. The key assumption of CAPM is that the investors will measure the risk of an
asset in comparison to the contribution in makes to the systematic or market risk of the
portfolio. The CAPM assumes that the investors in the market are perfectly rational and
want more wealth. It is also assumed that rational investors are risk averse. When an
investor thinks of holding a security, he considers the amount of extra risk that will
added to his portfolio. Also, the investor requires additional risk premium to hold the
additional market risk. The expected premium for additional risk (expected return less
risk free rate) is the product of the beta and the market risk premium. Here in the theory,
the portfolio of market is the value weighted average portfolio of all the risky securities
of the market. In most of the cases the market portfolio is not calculated or takes a lot of
time. In these cases, market proxies such as Wilshire 5000 and S & P 500 indexes are
considered.

Beta is also a requirement for the CAPM formula to be enacted. A beta is a

measurement of covariance of a security with the overall market. A beta less than one
shows that the portfolio will have a return less than the market and a higher than one
shows that the return will be higher than market. A zero beta implies a riskless security
such as government bonds. The riskier assets have greater betas. All the investors in
the market tend to balance their investment risk by investing in some risky assets and
some risk less ones. This idea is called the “Two Fund Separation Theorem”. In this
way a risk lover investor will take more risky securities and a risk-averse investor will be
investing in more risk free assets.

There are other complex versions of CAPMs available as well. Researchers have
extended the basic CAPM theory to be compared over different regional returns and
over different periods of time as well. CAPM is the simplest process available for asset
pricing. Its assumptions are quite simple on the basis of the rationality of the investors in
market and thus there is an opportunity for improvement in the theory.

An investor must also look at the time period of investment. At one’s investment
decision, time dimension plays an important role as the value of return tends to fall over
longer periods of time. CAPM implies that a modern investor will be happy to invest if
the investment portfolio gives a relatively higher return over time over the market
portfolio. Although the inter-temporal CAPM considers time period in the analysis, it is
usually not enough to satisfy the investors. The contemporary investors are also
concerned about the time period like the modern investors.

The issue of principals and agents

At this point, it is necessary to distinguish the two related parties of investment. One is
the principal who owns money but do not actively manage the portfolio and the other is
the agent who makes decisions regarding investment on behalf of the principal. Since
the ease of investment, the investment in portfolios has increased all over the world. In
USA, the active management has increased from $400 billion in 1981 to $6.7 trillion in
1998. Also, the passive portfolio management has risen from $241 billion to $5.5 trillion.
So the application of agents has increased over the time as well.
But this is to be noted that whether active management or passive management, neither
the principal nor the agent should be ignorant about the industry benchmark or the peer
portfolios. Ignoring the benchmark can be hazardous to the returns and it often takes a
lot of courage to construct portfolios independently. In case of principals, since they
know the basis of their investment decision can ignore benchmarks and can apply their
own money in any way they prefer. But the agent, dealing with the principals’ money,
has to have justification for any actions they take. That is why, for the agents, other
factors like proper valuation of securities in the portfolio influence buy and sell
decisions, thus affecting the overall price of the securities. So in order to create a
perfect measuring mechanism, all these factors must be incorporated in the model. But
sadly, the previous CAPM models only considered investors are principals. That is why
important factors such as market structure and behavioral patterns of different investors
and agents are overlooked. That is why although the previous tests had correctly
rejected the CAPM, did so on wrong and incomplete assumptions.

As spoken earlier, there is an increasing trend in investment in pension funds and

mutual funds. So, according to the principal-agent theory or agency theory by Fama and
Jensen (1983), there is high probability that the agents will continue to misprice the
securities. Unless the use of agents is completely abolished or the investment in
pensions is completely eradicated, the regular CAPM system will not be able to predict
the pricing of securities correctly. Since it seems none is going to happen, the agency
risk will continue to mislead the current CAPM model.
New Approaches to CAPM and its alternatives

As stated earlier, the existing model of CAPM is not the best possible model for asset
pricing. It has the simplest assumptions and often does not provide accurate result. So
there are opportunities for better and more complex models. That is why, multifactor
models were brought into action. There are a number of multifactor models such as
Arbitrage pricing theory, the Fama French Model (three factor model), Carhart Model,
Pastor and Stambough model and other build up models. Let us discuss them
accordingly.

Arbitrage Pricing Theory

According to CAPM, the required return on asset has a linear relationship with only the
systematic or market risk. But studies show that considering market risk as the only risk
is not an appropriate system. Recent studies show that an additional risk variable is
needed to calculate the expected return on assets.

A set of results suggest that it is possible to use the knowledge of the market and
securities to produce profitable strategies. According to Banz (1981), stocks with small
capitalization can perform better than large capitalization stocks. According to Basu
(1977), low P/E stocks can perform better than high P/E stocks. Even the “value”
stocks, which have large book value to market value ratio can, perform better than
“growth” stocks, which have low book value to market value ratio (Fama and French,
1995).

Since there were so many limitations to CAPM, the Arbitrage Pricing Theory (APT) was
introduced (Ross, 1976). This model had only a few assumptions and better variables
for risk measurement were allowed. According to APT, there is not only a single risk
factor, but a number of risk factors in a perfectly competitive capital market. Investors in
such market prefer more wealth to less. The formula to APT is represented as,
E(rj) = rf + bj1RP1 + bj2RP2 + bj3RP3 + bj4RP4 + ... + bjnRPn

Where,

E(rj) = Expected return on the asset

rf = Risk free rate of return

bj = the volatility of the asset’s return with the return of the market/ Beta

RP = Risk premium of the associated factors.

According to APT, there are many factors that create impact on the expected return of
the assets. These factors can be different for individual region and economy. These
factors usually consist of expected inflation in economy, uptrend and downtrend in the
Gross Domestic Product (GDP), political turmoil, change of interest rates and others. In
this case, all these factors do not have the same level of impacts on the return. The
sensibility of all these individual factors is measured by bj or the beta. Considering such
factors will give more accurate result than just a single market factor. Thus the Arbitrage
Pricing Theory is a better predictor of expected return than CAPM.

Fama French Model (Three Factor Model)

According to the basic CAPM theorem, the only factor that influences the required
return of equity is the systematic or market risk. But after 1980’s, the empirical studies
showed that only market factor cannot explain the return. Empirical studies of stock
markets show that “Value stocks” often provide greater return than the “Growth Stocks”.
Whereas CAPM, due to its unconcern of the size factor of stocks cannot predict such
trends.
According to Fama and French (1993), CAPM model considers only one risk factor
(market factor), which makes it vulnerable to misinterpretation. This is why these
researchers introduced the Three Factor Model.

The 3 factors are:

Market Factor: This is similar to the single factor CAPM model. This factor considers
only the market value index which is excess of risk free rate.

Size Factor: This factor considers the size of stocks in relation with the market
capitalization. It is calculated as return to a portfolio consisting of small capitalization
stocks return less the large capitalization stocks return.

Value Factor: This factor is considered in the Fama-French three factor model. It is
calculated as the return of the portfolio of high book-to-market value stocks less the
return of the portfolio of low book-to-market value stocks.

The formula of the model is depicted as,

Ri = Rf + b1 market factor RMRF + b2 size factor SMB + b3 value factor HML

Here,

Ri = the expected return on portfolio

b1,2,3 = Sensitivity to the factors/ Beta

RMRF = market factor

SMB = Small minus Big/ Size factor

HML = High minus Low/ Value factor

So, clearly, as there are more considerations in the Three Factor Model about the
variability available in the market, it will definitely provide better predictions about the
expected return of the portfolio. This comparison will be discussed in the later part of the
article.

Carhart Model

In the field of asset pricing and risk return estimate, there have been other researches
and findings. First of it was the Carhart (1997) model, where Carhart has extended the
three factor model of Fama and French. Carhart model assumes that there is a fourth
risk factor that must be evaluated. This factor is named as the “Momentum factor”. This
factor is calculated on the fact that the stocks with positive past returns will be likely to
produce positive future returns. The factor is calculated by considering the average
returns of a number of stocks which have provided the best possible returns over last
few years less the average returns of a number of stocks which have provided the worst
returns over last few years. This factor is recognized as PR1YR.

The formula of the model is depicted as,

Ri = Rf + b1 market factor RMRF + b2 size factor SMB + b3 value factor HML + b4momentum factor PR1YR

Carhart has showed that adding the momentum factor in calculation increases the
accuracy of prediction as much as 15 percent and argues that the factor variable is
usually positive in nature.

Pastor and Stambough Model

Another important finding was found by Pastor and Stambough (2003). The Pastor and
Stambough Model or PSM dictates that the interested investors need an incentive to
hold the illiquid share. Thus the liquidity factor is the fourth factor to the Fama-French
Model. The liquidity factor can be calculated by considering the average return on
illiquid shares and the liquid shares. The return on liquid shares is subtracted from the
return on illiquid shares. This factor is called the liquidity factor and tries to equate the
difference between liquid and illiquid shares. The model can depicted in the following
form,

Ri = Rf + b1 market factor RMRF + b2 size factor SMB + b3 value factor HML + b4liquidity factor LIQ

Illustration and Comparison among the models

Capital Asset Pricing Model (CAPM):

The CAPM considers only a single factor to calculate the expected return on stocks, the
market factor. For this calculation purpose, let us assume that the risk free rate (Rf) at a
given point of time is 6%. The sensibility (b1) of the shares of a hypothetical company X
to the market factor is 1.1. Let us further assume that the market factor is 8%.

So, according to CAPM, the estimated return stands,

Rx = Rf + b1 market factor RMRF

= 6% + 1.1 * 8%

= 6%+ 8.8%

= 14.8%

So, the expected return on Company X’s stocks is almost 14.8%.

Arbitrage Pricing Theory (APT):

Let us assume that there are two risk variables in action. The first one is the change in
inflation rate (RP1) and the second one is the change in Real GDP (RP2). So,

RP1 = Unusual changes in the level of inflation. The risk premium for such factor is 2
percent for every 1 percent change in the rate. (k1=0.02)

RP2 = Unusual changes in the increase in real GDP. The risk premium for such factor is
3 percent for every 1 percent change in the rate. (k2=0.03)

rf = The return on a zero-beta or zero systematic risk asset (risk free asset) is 6 percent
(k0=0.06). Let us assume that there are two assets (namely asset x and y).

bx1 = the sensitivity of asset x to the change in inflation is 0.50 (bx1 = 0.50)

bx2 = the sensitivity of asset x to the change in real GDP is 1.50 (bx2 = 1.50)

by1 = the sensitivity of asset y to the change in inflation is 2.00 (by1 = 2.00)

by2 = the sensitivity of asset y to the change in real GDP is 1.75 (by2 = 1.75)

All these factors can be explained as the same process as beta in CAPM equation.
Since asset y is a higher risk asset than asset x, its expected return should be greater.
So, the overall expected return equation will be:

E(rj) = rf + bj1RP1 + bj2RP2 = 0.06 + (0.02)bi1 + (0.03)bi2

So, for asset x and y,

E(rx)= 0.06 + (0.02)(0.50) + (0.03)(1.50)

= 0.1150

= 11.50%
E(ry)= 0.06 + (0.02)(2.00) + (0.03)(1.75)

= 0.1525

= 15.25%

This gives a better result than CAPM, because of it considers two separate factors and
their sensitivity. Also, in this process, expected returns of each of the assets included in
the portfolio can be separately calculated. So in this sense, APT gives a better
prediction and result than the traditional CAPM.

Fama-French Model (Three Factor Model):

The Fama-French Model or Three Factor Model considers three risk factors to estimate
the expected rate of return. These factors are market factor, value factor and size factor.
For the company X, let us assume that the risk free rate (Rf) at a given point of time is
6%. The sensibility of the shares of a hypothetical company X to the market factor (b 1)
is 1.1, sensibility to size factor (b2) is 1.5 and sensibility to value factor (b3) is -0.5.

So, according to FFM, the estimated return stands,

Ri = Rf + b1 market factor RMRF + b2 size factor SMB + b3 value factor HML

= 6% + 8% * 1.1 + 4.33% * 1.5+ 3.17% * -(0.5)

= 6%+ 8.8% + 6.495% – 1.585%

= 19.71%

At the same level of risk free rate and market risk factor, the expected return in CAPM is
lower than the FFM return. This is due to the reason the reason that CAPM believes
that the investors are not interested in the size factor premium and value factor
premium. As CAPM believes that market factor premium covers all this issues. Or it
believes that the size factor premium and value factor premium are a result of
inefficiency in the market. But studies have shown that neither market factor premium is
enough to cover all the associated risks, nor is the market always inefficient. The
studies show that companies with small market capitalization and high book-to-market
value company shares can easily perform better than the big market capitalization and
low book-to-market value company shares over a long time horizon in an efficient
market such as US or UK.
Conclusion

CAPM has its own drawbacks. There have been many researches for and against the
CAPM method and thus it is very hard to come to a clear and unambiguous solution.
But it is also to be mentioned that there are strong evidences that the assumptions of
CAPM hinders it from providing an actual result. The main school of researchers, who
oppose the CAPM, are not really clear as well. This school is led by Fama, who has
been a strong supporter of CAPM until the 1990s.

Another fact that makes it difficult to come to a conclusion is that the tests used to
analyze the existence of CAPM have been little measurable and also lack in real world
applicability. To utilize the world of real world economics actual data analysis is very
important but this also creates problems when actual human behaviors are considered.
The fact that economic theories are mostly related with human behavior is a truth and it
is also true that often human behaviors are not quantitatively measurable. When
economists try to replace quantitative data with human behaviors, problem occurs due
to the uncertain and complex past, present and future economic environment.

But despite all the limitations, it can be said that although CAPM has been providing an
insight to the researchers about the asset pricing. The CAPM has been quite incomplete
due to its incomplete assumptions. Extended model of CAPM like FFM, Carhart Model
and Pastor-Stambough has been more accurate than the original theory due to their
extended assumptions. However even if all the evidences are against CAPM model,
investment analysts and researchers will probably have to continue to use some kind of
an index or CAPM based model to estimate the asset pricing until a better, unbiased
and complete model can be introduced for calculation of asset returns and pricing.

At last, it can be concluded that although “CAPM is dead” but it cannot yet be buried
entirely. Until a completely new and unbiased model can be introduced, the asset
pricing system will have to use this dead theory.
References

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