In the following essay I will be comparing and contrasting the effectives of the capital asset pricing model (CAPM), Arbitrage Pricing Theory, and the Fama-French three factor model when estimating the cost of capital and explaining performance of investment portfolios.
The CAPM model was developed by Sharpe (1964) to explain how capital markets set share prices. (Pike and Neale) In result of research by Sharpe (1964), Litner (1965) and Black (1972) the Capital Asset Pricing Model (CAPM) states “the relationship between beta (measure of volatility on portfolios/assets) and expected returns is linear, exact, and has a slope equal to the expectation of the market portfolio excess return”. CAPM makes the assumption that markets are efficient therefore suggesting that operators within the market have rational expectations, this assumption leads us to the first weakness of CAPM (Vernimmen, 2011). However, when estimating the cost of capital, CAPM is seen to be preferred compared to other asset pricing models simply due to its simplicity. In a survey conducted by the Association for Financial Professionals (2011) it was found that when estimating the cost of capital 87% of all firms and 91% of publicly traded firms used CAPM.
Guermat (2014) states that the results of CAPM are always correct in a technical sense however, whether it is accurate to reality is questionable. I argue that we can only achieve an effective result if variables such as beta and expected returns are
In Kurt Vonnegut’s eyes, America is being taught that some books and ideas are tantamount to diseases. As a consequence, the humorous, satirical novel Cat’s Cradle has been unjustly challenged in a few areas of the United States. The novel looks at the structures that curb our society, especially in religion and science, and contains an educational value that is paramount in correlation to its suggestive themes. Therefore, despite Cat’s Cradle’s minor suggestive content, including religious satire and mature themes, the book possesses important concepts that should not be overshadowed by these negligible reasons. It is puzzling how the novel received bans for such irrational conclusions.
CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.
This model is an expansion of the CAPM and it includes two additional variables, taking into account size and book to market factors, as explanatory variables expressed within the model as SMB and HML. The Capital Asset Pricing Model (CAPM) and Fama & French’s three factors model are both models account for the expected returns for stock albeit using different variables to distinguish and add reliability to the predictions of these estimated returns. However, the CAPM uses only one factor to determine the riskiness of the marketplace, Beta, whereas Fama & French expands on this model, incorporate another two factors to establish the risk, Small minus Big (SMB) and High Minus Low (HML), which take into account the relationships between market and share size. Hence, in Fama & French’s findings, stocks with higher beta did not always perform better. The Three Factor Model is indeed preferred at predicting the returns of stocks, in correlation with each models risk factor.
A lot of criticism on the CAPM has arisen over the last decades. One finding by Basu in 1977 is often used by opponents of the model in order to take down the foundation of the CAPM. Basu[3] found that stocks with a low price –earnings ratio, called value stocks, tend to outperform stocks with a high price-earnings ratio, named growth stocks. As the CAPM only allows for fundamental risk to explain excess returns on stocks, the finding that stocks from companies with high fundamentals (earnings, sales, dividends) relative to price outperformed growth stocks was in contradiction with the classical CAPM.
The expected return for each of the stocks has been calculated by the Capital Asset Pricing Model. The risk free rate is one of the variables used in the CAPM formula. The risk free rate has been assumed here at 7% based on historical statistics as no information has been given regarding it. The second variable is the return on market. This return has been estimated from the average monthly return by transforming it into effective expected annual rate of return. Finally, the third variable used in the CAPM formula is beta which has been calculated in the third question. This beta incorporates the systematic risk in the formula to calculate the expected return for a particular stock. The expected return for Brown Group is 14.87% and for California RIET it is 8.00%. This shows that the expected return for Brown Group is much higher than the expected return of California RIET.
The capital asset pricing model can be used to calculate the firm's cost of capital, or at least the firm's cost of equity. The cost of equity reflects the firm's cost of using equity capital to finance its operations. The use of CAPM is effective, because the beta is based on market performance of the company's stock. The market is assumed to be capable of making an accurate
Eugene Fama from the University of Chicago and Kenneth R. French from the Yale School of Management's were done a research on examining the validity of capital asset pricing model (CAPM). It was published in 1992; and well-known as The Fama-French three factors model (TFM).
Richard Roll, and University and Auburn, University of Washington, and University of Chicago educated economist, began his career researching the effect of major events of stock prices. This experience likely helped him reach the two conclusions he makes in his 1977 “A Critique Of The Asset Pricing Theory’s Tests”, one of the earliest and most influential arguments against CAPM. In the paper, Roll makes two major claims: that CAPM is actually a redundant equation that just further proves the concept of mean-variance efficiency, and that it is impossible to conclusively prove CAPM. His first claim relates to mean-variance efficiency: the idea that mathematically one must be able to create a portfolio that offers the most return for a given amount of risk. Roll claims that all CAPM is doing is testing a portfolio’s mean variance efficiency, and not actually modeling out projected future returns. The second claim in the paper is that there is not enough data about market returns for CAPM to ever prove conclusive. Even if modern technologies could help alleviate some of the burden of testing market returns for publicly traded equities, there is still no way to account for the returns of less liquid markets, where there is less public information. This means it is impossible for
Critical Analysis of the Relative Merits of the Capital Asset Pricing Model (CAPM) and the Fama and French (F&F) Three-Factor Model (TFM)
If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative, the CAPM would
Empirical evidence in the early years of CAPM provided support especially with Sharpe and Copper
There are many different asset pricing and portfolio management models available to assist us in the estimation and evaluation of a stock’s return. The Fama-French Model (“FFM”) is one of those models. Kenneth French and Eugene Fama who were professors at the University of Chicago Booth School of Business designed the FFM. Kenneth French and Eugene Fama observed that historically, the Capital Asset Pricing Model (“CAPM”), which was predominantly used, was inaccurate as it often resulted in high alpha values which meant that a huge portion of excess returns were left unexplained. They also observed that companies with smaller market caps would outperform companies with higher market caps and companies with higher book-to-market (“B/E”)
In order to maximize a portfolio’s return, it is important to analyze risk and diversify securities, while adhering to the goals of an investor. Through analyzing the different classes of risk, one can match investments to an investor’s risk tolerance and return requirements. Even though some investments may present greater risk they are countered by a higher rate of return and vice versa, less risk corresponds to a lower return. Moreover, investment risk can be substantially reduced through diversification, which spreads a portfolio across different industries, businesses and investment options. The makeup of a diversified portfolio continually changes based on an investor’s time horizon and investment goals. In accordance with the Modern Portfolio Theory (MPT), one can maximize return while reducing risk, through assessing investments standard deviation and beta. When applied to the capital asset pricing model (CAPM) an investor can determine what the expected rate of return should be and if the risk is worth it. Therefore, by analyzing risk and diversifying investments one can maximize an investment growth, increasing a portfolios return.
The nineteenth century was a period of revelation and magnification for the Coalesced States of America. The Westward Expansion emerged by America’s desire to expand economically and territorially. Driven by the compulsion of consummating their manifest destiny, many Americans packed their paraphernalia, got their families yare, and commenced their peregrination to the West of the Amalgamated States. This great migration was mostly done utilizing wagon trains (Corbett et al., 2016, 481). Most Americans and immigrants peregrinated along trails, such as the California, Santa Fe, and Oregon Trail, to get to the West. These trails were long, exhausting, and lacked safety. In 1862, with the approbation of the Pacific Railway Act, this migration to the West took a crucial turn. This act sanctioned the Cumulation Pacific Railroad and the Central Pacific Railroad, to build an incipient track that connected the East and West of the Cumulated States. This incipient track is better kenned as the first transcontinental railroad. The development of the first transcontinental railroad was responsible for a substantial increase in the Westward Expansion from 1870 through 1890.