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): 42765. http://onlinelibrary.wiley.com/doi/10.1111/j.15406261.1992.tb04398.x/abstract (accessed March 17, 2013). Kuehn, Lars-Alexander, Mikhail Simutin, and Jesse Wang. “A Labor Capital Asset Pricing Model.” (February 2013): 156.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): 2546. 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): 26392. http://www.hss.caltech.edu/~camerer/Ec101/ProspectTheory.pdf(accessed April 7, 2013).