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Course ECON1106: Econ of Finance & Invest (M) Course School/Level BU/PG
Coursework Coursework Essay Assessment Weight 60.00%
Tutor B TBA Submission Deadline 12/01/2011

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000602405 Kazim Khan

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Is CAPM Is Feasible In Financial Market
Or Not?

A bstract:-This paper explores the several studies done on CAPM. To

explain CAPM is dead and if it is so than on what ground it depict

by several researcher since CAPM is exists. Demonstrate model

contributed by various researcher including Fama and French three factor

model on portfolio by book-to-market and size characteristics. Cross-

section of average return on assets influences also enclosed in this study.

Introduction:- CAPM (capital assets pricing model) initiate by William Sharp in

1964 and followed by the John Linter in 1965 as mean-variance capital asset

pricing model. This invention leads to extensive use of CAPM in application in

context of the evaluation the performance of managed portfolios and

estimation of the cost of the capital of the firm. CAPM developed intuitively

and powerful pleasing prediction linked to the prediction to measure risk. Also

measures relation between risk and expected return.

Purpose, logic of CAPM and timeline so far :- Harry Markowitz (1959) state

CAPM model of portfolio choice in his model he propose that an investor select

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a portfolio at a time t-1 that mean it produces a stochastic return at t. Model

assumes investor are risk averse. In this model it has been assume that

investors are risk averse while selecting among several portfolios. These

investors only care about variance and mean of their one period investment

return. Respectively they choose portfolio enhanced with mean-variance-

efficient, in a sense that portfolio acquires certain qualities 1) maximised

expected return at given variance. 2) Minimise the variance of the portfolio

return, given expected return. Therefore this approach of Markowitz called

Mean variance model. An algebraic term on asset weights in mean variance

efficient portfolio has been provided by this portfolio model. Hence role of

CAPM is to convert such algebraic term into the testable prediction or

reasonable approach accompanying to the relation between expected return

and risk by categorizing a portfolio that must be competent if assets price is

clear to market of all the assets.

Later on Markowitz model research equipped with two more assumptions by

Sharp (1964) and Lintner (1965) First assumption is complete agreement

assumed market capital assets price at t-1 investors agree on joint distribution

of asset return from t-1 to t. Second assumption that there is lending and

borrowing at a risk free rate, this is same for all the investors and irrespective

to the borrowed and lent.

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Figure (a) express CAPM and describe portfolio opportunities. Here portfolio

risk is shown on the horizontal axis portfolio risk is measured by the standard

deviation of portfolio return. Expected return demonstrates on the vertical

axis. Curve in graph abc also known as minimum variance frontier, curve

indicate combination of expected return and risk for portfolios of risky assets

that minimize return variance at the different level of expected return. In this

assumption risk-free lending and borrowing excluded. Trade-off between

expected return and risk for minimum return portfolio is deceptive. For

instance it can be explain as an investor who is eyeing for high expected

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return, possibly at point a high volatility believed. Investor can have

intermediate expected return along with lower volatility at point T. only

portfolio b among abc is mean-variance efficient if there is there is no risk-free

lending and borrowing. Assumed portfolio also maximise expected return, at

their return variance.

Now adding risk-free lending and borrowing transform the efficient set into the

straight line. Consider a portfolio from which x amount of portfolio funded in a

risk-free security and 1 - x in other portfolio say g. Apart from this if all fund

invested in the risk-free securities i.e. they are loaned at risk-free rate of

interest in above figure show it as point , portfolio with a risk-free rate of

return and zero variances. Combination of positive and risk-free investment in

g which is plot on the straight line between g and . Point after g on right side

of the line represents borrowing at risk free rate, borrowing continue increase

investment in portfolio g. it can be determine that risk-free borrowing and

lending along with some risky portfolio, in figure (a) g plot at straight line from

through g.

Hence, return standard deviation and expected return of return on portfolio

and on risk-free asset f and risky portfolio g differ with x. the proportion of

funds invested in f, as

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 =x + (1-x)

E( )=x + (1-x) E ( )

σ( ) = (1-x) σ ( ), x ≤ 1.0,

This equation together imply that the portfolio plot along line from through

g. To acquire the mean-variance-efficient portfolios which is available with risk-

free lending and borrowing one line move in curve from in figure (a)

Although to get the mean variance efficient portfolio along with risk-free

lending and borrowing, we need to swings the line from the in figure (a)

upward and left as much as possible, To tangency portfolio T. Now we can

recognize that all efficient portfolios are combination of risk free asset and

single risky tangency portfolio T. So after complete understanding about

distribution of returns all of the investors looking forward for same

opportunity set as seen in figure (a) therefore they combine the same risky

tangency portfolio T with risk-free borrowing and lending. Subsequently most

of investors clench the same portfolio T of the risky assets hence it must be the

market portfolio of risky asset. Precisely every risky asset weight in the

tangency portfolio, Can be denoted by M for market. And entire market values

of outstanding units of the asset divide by the whole market value of total risky

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asset. Along with this an additional risk-free rate must be set to clear the

market for risk-free lending and borrowing.

So point can be made that the CAPM assumption suggests that the market

portfolio M have to be on the minimum variance frontier if the asset market

has to be clear. This mean minimum variance portfolio M hold by algebraic

relation should also hold market portfolio. Precisely in case of N, mean there is

N risky assets.

Following equation we get

At minimum variance condition for M E( )=E( )

+ {E ( )-E ( )} i = 1,…, N.

In this equation expected return on the asset i and is denoted by E ( ).

Here along with market return, market beta of asset i is covariance of its return

is divided by the variance of the market return,

We get this equation =

This equation states that returns are uncorrelated with the market return also

concluded by first term that is on right hand side of minimum variance

condition E( ). Here E( ) is expected return on the assets in which

market beta is equal to the zero. Risk premium is second term particularly for

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market beta of asset i, unit of beta is determine by times premium per

unit. This is expected market return E ( ) less E ( ).

Asset i of market beta is a also slope in regression of its return on the market

return. Beta measure sensitivity of the assets return to variation in the market

return this is common interpretation method uphold by beta. Another

common interpretation construct here by beta is related to portfolio model

under the CAPM risk of market portfolio and it is measured by the variance of

its return which is denominator of it is also weighted average of

covariance risk of the assets in M. so is variance of market return and

covariance of risk of assets i in M express average covariance of asset. As far as

concern about in economic term it is proportional to risk in investing a

single pound asset i contribute to market portfolio.

Final step complete Sharp-Lintner model, to employ hypothesis of risk-free

lending and borrowing to nail down E ( ), the expected return on zero-beta

return. As we assume risky asset return is related to market and it

uncorrelated its beta is zero. While average of asset covariance as per return

on other asset unbiased offset the variance of the asset return. Such risky asset

contribute nothing to the variance of the market return hence it is riskless in

market portfolio sense. If there is risk-free lending and borrowing, than

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expected on assets is which is uncorrelated to market return E ( ) also equal

with the risk free rate . The relation between beta and expected return

Sharpe-Lintner CAPM

E( = +{E - } i = 1,…, N.

In this model expected return on the asset i, is at risk-free interest rate along

with risk premium, . This is asset of the market beta and E - is

times premium of beta risk. Here hypothesis is short selling is unrestricted

is as unrestricted risk-free lending and borrowing. In this assumption there are

no short sales and risk-free asset of risky asset are not allowed. Efficient

portfolio will be chosen by mean variance investor point b in abc curve in

figure (a). Market portfolio made up of efficient portfolio is not typically

efficient this is arisen by algebraic of portfolio efficiency. And CAPM relation

between market beta and expected return is lost. Hence it denies prediction

about beta and expected return related to other efficient portfolios with

respect to theory that can specify portfolio which must be efficient with clear

market. Till now it is not feasible. Overall CAPM equation concerning expected

asset return to their respective market and beta is an application to a market

portfolio of the relationship between beta and expected return that control

under any mean variance efficient portfolio. Many unrealistic assumptions

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grounded to measure efficiency of market portfolio, inclusive complete

agreement unrestricted risk-free lending and borrowing or short selling of risky

asset which is also unrestricted.

Beta is dead: - Fama and French in 1992, Roll and Ross in 1996 and other

literature studied beta is dead. Fama and French develop two negative

determination related to empirical competence of CAPM of Sharp and Lintner

(1965) this are

 Beta is not sufficient enough to describe average return. As far as

concern about difference in average stock return for market

capitalization size during 1961-1990.

 One variation for beta is allowed in market is that it is not related to

the size but univariate relation among average return for 1941-1990

and beta is weak.

Also three factor model by Fama and French (1993, 1994, 1995 and 1996) for

stock portfolio throw light on the point that if beta is dead they why it is so.

This is a three factor model equation as follows:-

{ }

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Here

= Risk free rate at time t,

= Expected return of stock at time t,

= Excess return of high over low B/M ratio portfolios at time t,

= Excess return of small over large portfolio at time t,

= Random error term at time t,

To justify research on CAPM that whether it is dead or alive Fama and French

for their three factor model organise 25 based on B/M equity ratio and frim

size. Statistic for their studied is table 4, 5 and 6 of 1993 which is consolidate

here in table a. table a shows that value of for factor excess market alone

and a three factor model are similar in some reasons these are.

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 Table a

Fama and French, Key Statistics of Test Results for Tables 4, 5 and 6 of
1993

Statistics Explanatory variables Excess return of small Excess market, SMB and

excess market alone over big portfolios and HML

Excess return of high

over low book-to-market

equity (B/M) ratio

portfolios

Highest 0.92 0.65 0.97

Adj Lowest 0.61 0.04 0.83

Average 0.78 0.38 0.93

Highest 22.5 52.58

Lowest 2.78 |-1.18|

Average 12.6 25.84

% significance 25/25 24/25

Highest |-12.25| 24.80

Lowest |-0.05| |-0.05|

Average |-6.15| 12.38

% significance 16/25 21/25

Highest 61.51 61.54

Lowest 23.01 38.61

Average 42.26 50.08

% significance 25/25 25/25

Source: - Fama and French (1993)

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 1. Consider coefficient of t-values of the of the excess market return. These

are significant. This coefficient beta measures elasticity of excess

portfolio return with respect to excess market return.

2. This point emphasis on the frim size effect information available. Here it

is concluded that arbitrage process is retard by the size premium and

existence of market friction. This is so because size premium persist can

be understood specially concern in market fraction in relation of

financial and real sector. As in real sector monopoly rent is created by

imperfect competition this lead to manufacture in large firm at average

cost and it is lower than small firms. Rising of such cost difference

because of monopoly rent is not arbitrageable despite the fact that

information about firm’s size is available. As far as concern about the

financial sector it is fact that small firm experience high information,

financing and transaction costs related to their stock price compare to

large firms. In spite of the fact that this cost may be lesser and can

become large if joined together hence arbitrage processes are retarded

and discourage by these market frictions.

3. This consideration is about the book-to-market equity (B/M) ratio. At

market which is frictionless. So without any clarification it is known that

book value is vary from market value. Still market friction exists and

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 economic income is deviate from accounting income and also market

value and book value both are different. After going through it can be

conclude that B/M ratio also trace back to market friction that retarded

arbitrage process.

Hence all these explanations come up with point that beta is not suitable and

weak because observed return is polluted by market friction.

This model gives better explanation regarding average return and it is also

acquire most of the average return anomalies neglected by CAPM. Model

consists of strong theoretical understanding and development of three risk

factors in model related to excess market return. Finding by KOTHARI,

SHANKEN, AND SLOAN (KSS 1995) confirm it is important. As it capture time

series variation in return and to explain great difference between average

returns on bills and stock market premium is needed. CAPM declares market

premium on multifactor model is just average return on the M in risk-free rate.

Assessment on long sample declares premium is reliably positive. All in all test

on CAPM by KOTHARI, SHANKEN, AND SLOAN (KSS 1995) against multifactor

alternative depict positive beta premium does not itself resuscitate the CAPM

nor justify its use and It has been found by KOTHARI, SHANKEN, AND SLOAN

(KSS 1995) that beta is not sufficient to describe expected return.

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Literature review:-

Apart from this KOTHARI, SHANKEN, AND SLOAN (KSS 1995) argues that

survivor bias in COMPUSTAT data play prominent role in creating positive

relation between book-to-market-equity (BE/ME) and average return.

Statement also appreciated by the Fama and French (1992). COMPUSTATA

more potential to add firm facing financial trouble those survive to miss

distressed firm that die. Even such survivor firms likely to have unexpectedly

high return in turnaround year as they added in COMPUSTAT. It has been

verified by some evidence that survivor bias is not able to explain relation

between BE/ME and average return. But counter approach has been prepared

by Lakonishok, Shleifer, and Vishny (1994) according to them there is strong

and positive relation among BE/ME and average return for largest stock about

20 percent of NYSE AMEX. Fama and French 1993 found that relation between

average return and BE/MA strong for value weight portfolios of COMPUSTAT.

Finding of KOTHARI, SHANKEN, AND SLOAN (KSS 1995) over survivor bias and

BE/ME that there is little relation between average return and BE/ME for

limited industry portfolio in S&P indices.

Findings: - This study reveals that relation between BE/ME and average return

is completely result of survivor bias.

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CAPM has certain limitations which lead to make an opinion that CAPM is dead

these are as follows:-

a) In studies of the CAPM applied to common stocks, the CAPM does not

explain the differences in returns for securities that differ over time,

differ on the basis of dividend yield, and differ on the basis of the market

value of equity this is also define as size effect.

b) CAPM contains some unrealistic assumption such as all investors can

lend and borrow at same rate or they have homogeneous expectations.

c) Beta is an estimate of systematic risk. Particularly for the stocks, and it is

typically estimated using historical returns. But the estimate for beta

depends on the period and method in which it is measured. For assets

other than stocks, beta estimation is more difficult.

Cross-section of average return studied and developed by several researchers

Kan and Zhang (1999), Chen and Kan (2006), Lewellen et al. (2006) and

shanken and Zhou (2007). To explain cross-sectional CRPS index has used as

market portfolio. Unconditional model meant by conditional CAPM which

describe about 30 percent of cross-sectional in average return of 100 stocks.

To use CAPM practically stock exchange such as AMEX and NYSE are commonly

use as value weighted portfolio. This is best assumption to demonstrate return

on market portfolio on assets. Fama and French 1992 suggest that cause of

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unsatisfactory performance of CAPM is use of return on market portfolio on all

assets. So Mayers (1972) approach point out that human capital perform

important part for gross capital in the economy.

Cross-sectional annual return on asset following regression model is construct

to study cross sectional propose by Black, Jensen, and Scholes (1972) and Fama

and MacBeth (1973).

Literature review: - To explain effect on cross-sectional ten portfolios of NYSE

stock on CRSP starting from 1927 based on value weight beta, in this study

formation period use 24 to 60 month for past return, but 1927 is exception

here 18 month is used by researcher return on deciles from June to July from

July 1927 to December 1993. Panel A and panel B, panel A estimate using

postformation monthly or annually. Panel B shows t-statistic and average

slopes or mean from univariate cross-section regress of postformation

annually and monthly return. In cross-section regression KOTHARI, SHANKEN,

AND SLOAN (KSS 1995) describe monthly return with from regress of annual

return on equal weight market return. This debatable assumption acquire by

KOTHARI, SHANKEN, AND SLOAN (KSS 1995) in explaining cross-section

regression as this is apart from CAPM sprit because of earlier study done by

Rolls and Ross (1994) and Kandel and Stambaugh (1995). According to Kandel

and Stambaugh if market proxy is not mean variance efficient conferring

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parameters calculated from the model data. Through any ordinary least

squares cross-section regression it is feasible to create portfolio which produce

essentially any univariate premium. Such assumption regarding premiums

also relates cross-section regression that uses other variables including to

explain average return. Furthermore GLS (generalised least square) regressions

describe in Amihud, Christensen and Mendelson (1992) is not appropriate. It

has been distinguished Roll and Ross (1994) that positive premium in

univariate GLS cross-section regress depict market proxy shows more expected

return than global minimum variance portfolio.

Conclusion: - It has been seen that different researcher has dissimilar approach

toward CAPM. But CAPM is very commonly used by investors, share analyst

and business to calculate return on assets and on equity as well. This means all

practical and conceptual issues surrounding its practicality and validity hence it

worth getting to grip with it. Like every coin have two sides so that researcher

have different point of view regarding CAPM but it hard to say that “CAPM is

DEAD” if CAPM was dead then it was never been implement by anyone. CAPM

is root for business decisions as most of business decisions are relay on CAPM,

as it deliver appropriate evidence to support analyses in business and CAPM

least some share and asset price is also determined by CAPM. Overall CAPM

popularity makes it self-fulfilling.

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References:-

 Copeland, Shastri, Weston (2005), “Financial Theory and Corporate

Policy” 4th edition p.p 147-188

 Ravi Jagannathan and Zhenyu Wang, The Conditional CAPM and the

Cross-Section of Expected Returns, online {available}

http://www.jstor.org/stable/2329301 { Accessed: 07/01/2011}

 Janmaat and Grauer (2009) online {available}

http://www.sciencedirect.com/science?_ob=MImg&_imagekey=B6VCY-4THC1D3-1-

F&_cdi=5967&_user=634187&_pii=S0378426608002100&_origin=search&_coverDate=05/3

1/2009&_sk=999669994&view=c&wchp=dGLbVtb-

zSkzS&md5=22facef06cde86ddd58006e6c1e9b38c&ie=/sdarticle.pdf { Accessed:

06/01/2011}

 Black, F., (1972). Capital market equilibrium with restricted borrowing.

Journal of Business 45, 444-454. online {available}

http://web.ebscohost.com/ehost/viewarticle?data=dGJyMPPp44rp2/dV0%2bnjisfk5Ie46bN

Qsq6uULak63nn5Kx68ea%2bTq2nt0ewpq5Pnqu4TbKwr0uexss%2b8ujfhvHX4Yzn5eyB4rOrSb

WorkivrLVKtZzqeezdu33snOJ6u9jzgKTq33%2b7t8w%2b3%2bS7TLOutEuypqR%2b7ejrefKz7n

zkvPOE6srjkPIA&hid=19 { Accessed: 05/01/2011}

 Sharpe, W. F., (1964). Capital asset prices: A theory of market

equilibrium under conditions of risk. Journal of Finance 19, 425-442.

20 Kazim Khan 000602405

 online {available}

http://web.ebscohost.com/ehost/viewarticle?data=dGJyMPPp44rp2/dV0%2bnjisfk5Ie46bN

Qsq6uULak63nn5Kx68ea%2bTq2nt0ewpq5Pnqu4TbKwr0uexss%2b8ujfhvHX4Yzn5eyB4rOrSb

WorkivrLVKtZzqeezdu33snOJ6u9jzgKTq33%2b7t8w%2b3%2bS7TrSptUy3rKR%2b7ejrefKz7nz

kvPOE6srjkPIA&hid=19 { Accessed: 04/01/2011}

 Hsia, C. C., Fuller, B. R., and Chen, B. Y. J., (2000). Is beta dead or alive?

Journal of Business Finance and Accounting 27, 283-311. online

{available}

http://web.ebscohost.com/ehost/viewarticle?data=dGJyMPPp44rp2/dV0%2bnjisfk5Ie46bN

Qsq6uULak63nn5Kx68ea%2bTq2nt0ewpq5Pnqu4TbKwr0uexss%2b8ujfhvHX4Yzn5eyB4rOrSb

WorkivrLVKtZzqeezdu33snOJ6u9jzgKTq33%2b7t8w%2b3%2bS7S7Crt1Gwp6R%2b7ejrefKz7n

zkvPOE6srjkPIA&hid=19 { Accessed: 05/01/2011}

 Fama, E. F. and French, K. R., (1992). The cross-section of expected stock

returns. Journal of Finance 47, 427-466. online {available}

http://web.ebscohost.com/ehost/viewarticle?data=dGJyMPPp44rp2/dV0%2bnjisfk5Ie46bN

Qsq6uULak63nn5Kx68ea%2bTq2nt0ewpq5Pnqu4TbKwr0uexss%2b8ujfhvHX4Yzn5eyB4rOrSb

WorkivrLVKtZzqeezdu33snOJ6u9jzgKTq33%2b7t8w%2b3%2bS7TLSrsE2yrKR%2b7ejrefKz7nzk

vPOE6srjkPIA&hid=19 { Accessed: 07/01/2011}

 Richard C. Grinold, Is Beta Dead Again?, online {available}

http://www.jstor.org/stable/4479665 . {Accessed: 07/01/2011}

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  Kevin Q. Wang, Asset Pricing with Conditioning Information: A New Test,

online {available} http://www.jstor.org/stable/3094484 {Accessed:

01/01/2011}

 Website :- http://www.scribd.com/doc/16743809/CAPM {Accessed:

04/01/2011}

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