An Overview and critique of the capital asset pricing model

An Overview and critique of the
capital asset pricing model
Presenter: Sarbajit Chakraborty
Discussants: Gabrielle Santos
Ken Schultz
Theory and Applications
Possible Critique
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.
To understand the underlying theory of CAPM
we first have to discuss two very essential
concepts related to the theory:
The Capital Market Line(CML)
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
Security Market Line
Also follows a liner
relationship between
the Expected return
And Beta
The CAPM is an ex-ante, static(one period
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.
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
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.
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
“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”
CAPM &the labor theory of value
Labor search frictions are an important
determinant of the cross-section of equity
As an equilibrium outcome of the labor market,
labor market tightness is negatively related to labor
market participation shocks
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
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Kuehn, Lars-Alexander, Mikhail Simutin, and Jesse Wang. “A Labor Capital Asset Pricing
Model.” (February 2013): 156.
%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. (accessed
April 7, 2013).
Amos Tversky, Daniel Kahneman. “Prospect Theory: An Analysis of Decision under
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