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CAPM Recap

CAPM Recap. The expected return on an asset is written as E(r i ) = R f + Beta i [E(r m ) – R f ] Beta = Cov (R i , R m ) / Var (R m ) The market is mean-variance efficient An asset’s expected return is related to its level of systematic or non-diversifiable risk as represented by Beta

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CAPM Recap

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  1. CAPM Recap • The expected return on an asset is written as • E(ri) = Rf + Betai [E(rm) – Rf] • Beta = Cov (Ri, Rm) / Var (Rm) • The market is mean-variance efficient • An asset’s expected return is related to its level of systematic or non-diversifiable risk as represented by Beta • The excess return on an asset over and above that predicted by CAPM is the asset’s Alpha • Over time, an assets alpha is expected to be 0 • e, The non-systematic, firm specific variance is also expected to be 0 over time. Intermediate Investments F303

  2. Critiques and Criticisms of CAPM • Roll’s critique • Identifying the market portfolio • Are the arguments surrounding CAPM really circular in nature? • Roll maintains that CAPM is not testable • Does the existence of Alpha indicate a bad model or market inefficiency? • Recall the example of the Franklin Income Fund, the DJIA and Salomon’s High Grade Bond Index • Was the Franklin Funds under-performing alpha the result of a bad model or market inefficiency? Intermediate Investments F303

  3. Stock Return Anomalies • The small firm effect • Small market cap returns • January effect • The liquidity effect • Amihud and Mendelson argue Beta ineffective in predicting the returns of less liquid assets • Calendar effects • January effect (again!) • Day of the week effect Intermediate Investments F303

  4. Stock Return Anomalies (cont) • The Earnings / Price effect The CAPM debate has gone in three stages: • Support • Critique based on Fama and French • A return to support Intermediate Investments F303

  5. The CAPM Debate • Fama and French • Beta not an effective predictor • Prefer firm size and book to market ratios • Black, Scholes and Jensen • Support for a linear relationship, but there was a permanent existence for alpha • Critique of Fama and French • Errors in methods, sample size and sample periods • A survivorship bias • In the end, beta is still an important factor in predicting returns, it is simply not the only one! Intermediate Investments F303

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