CAPM--The Capital Asset Pricing Model

CAPM is one of the most widely talked about and used models. Some claim it does not work while others believe it is best thing ever. This path looks at CAPM from then to now.

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    Capital asset pricing model

    In finance, the capital asset pricing model ( CAPM) is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non- diversifiable risk.

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    CAPM: The First Factor of Investing

    A group of our advisors attended a conference this past fall sponsored by Dimensional Fund Advisors. In his talk,

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    Capital Asset Pricing Model - Risk Encyclopedia

    This is very good William Sharpe ( 1964) published the capital asset pricing model (CAPM). Parallel work was also performed by Treynor ( 1961) and Lintner ( 1965). The model extended Harry Markowitz's portfolio theory to introduce the notions of systematic and specific risk.

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    Revisiting the Capital Asset Pricing Model

    A good recap of where the world was BEFORE the Fama-French three-factor model. by Jonathan Burton Reprinted with permission from Dow Jones Asset Manager May/June 1998, pp. 20-28 For pictures and captions, click here Modern Portfolio Theory was not yet adolescent in 1960 when William F. Sharpe, a 26-year-old researcher at the RAND Corporation, a think tank in Los Angeles, introduced himself to a fellow economist named Harry Markowitz..

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    Fama-French Three Factor Model

    "The Fama-French Three Factor Model provides a highly useful tool for understanding portfolio performance....The Three Factor Model takes a different approach to explain market pricing. Fama-French found that investors are concerned about three separate risk factors rather than just one. Actually, they found that in the real world, investors care about lots of different risks. But, the risks that have systematic prices attached to them and that in combination do the best job of explaining performance and pricing are market, size and value.",

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    Fama and French three-factor model

    The Fama and French three-factor model is used to explain differences in the returns of diversified equity portfolios. The model compares a portfolio to three distinct risks found in the equity market to assist in decomposing returns. Prior to the three-factor model, the Capital Asset Pricing Model (CAPM) was used as a "single factor" way to explain portfolio returns.

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    Fama and French on early critics of their work

    A 1996 paper by Fama and French giving a more historical look at what was seen as the death knell for CAPM. (in essence this paper, it appeared in the Journal of Finance and this summary was in the CFA digest, responds to criticisms of their own paper that was accused of killing off CAPM.

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    CAPM is dead? if not, at least in the ICU

    After Fama-French's work came out, the view (especially in academia) was that CAPM was on the way out.

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    CAPM is CRAP, or, The Dead Parrot lives! - John Mauldin's Outside the Box - Investment Strategies, Analysis & Intelligence for Seasoned Investors.

    A practioner's attack of CAPM. Introduction Within human nature there is a tendency to search for reasoning or logic to validate our own actions. This holds true in the academic sector as models are derived to provide an answer to a scenario, but sometimes such models do not translate well from the world of academia into that of the real world.

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    Estimation of Expected Return: CAPM vs Fama and French

    Most practitioners favour a one factor model (CAPM) when estimating expected return for an individual stock. For estimation of portfolio returns academics recommend the Fama and French three factor model. The main objective of this paper is to compare the performance of these two models for individual stocks. Key takeaway: neither CAPM or Fama-French did a great job and CAPM is easier.

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    FinanceProfessor.com

    A dated (from 2004) article, but a good review of how CAPM came about and why Galagedera provides an excellent review of the Capital Asset Pricing Model. From its beginnings (growing out of the work of Markowitz), to its possible demise the paper reviews the history of CAPM without breaking any new ground, but rather assuring that we are all up to speed with what has been done.

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    Don't bury CAPM yet!!

    Even if CAPM were "dead", it would be well worth studying it as it laid the foundation for other asset pricing models by succinctly showing the importance of systematic risk.  

    But what is even more important is that after many  "CAPM is dead, CAPM is dead" papers, there is now a growing amount of research that suggests that CAPM is still valuable.

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    The Progeny of CAPM

    This paper reviews the recent literature on CAPM and APT, and reaches a surprising conclusion. While APT died a silent death, CAPM's progeny is alive and well!

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    Is Beta Still Useful Over A Longer-Horizon? An Implied Cost of Capital Approach by Shi and XU

    I was lucky enough to be at this session in Nashville and was blown away by the presentation. Short version: While CAPM may not work in the short term, it appears to work reasonably well at longer term windows.

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    My conclusions

    CAPM is a good model.  It helps us to understand that systematic risk matters and that asset specific risk SHOULD NOT matter.  

    Fama-French (https://en.wikipedia.org/wiki/Fama%E2%80%93French_three-factor_model) showed definitively that CAPM was not the best predictor of returns in the short run.  But even here, it should be noted that the idea of systematic risk being the key is upheld (FF just measure it differently).  

    After a few decades of confusion (where CAPM was criticized in academia but then still used in the "real world"), in recent years some work has at least suggested that CAPM does in fact work in the longer term.  Shi and XU show this using firm's cost of capital (a longer term variable than periodic expected returns).  Also (and I could not find a good link to this), Jonathan Berk in his FMA Keynote address in 2014 said that Beta was still a good predictor of returns for mutual fund managers in the longer term--here is the best link I can find: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2408231). 



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