Capm Vs Sml Plus The Level

However, while this may be the case, many criticisms of the model remain.

While it may not be the most efficient asset pricing model, due to reasons I will discuss further on, it is still widely regarded as the default model for asset-pricing in relation to risk.

For this reason alone, I feel that the model merits a dedicated blog of its own.

Agenda-wise, I will begin by explaining what the CAPM actually is and why its used, and then subsequently move on to analysing some other similarly relevant topics through both theoretical and practical examples.

Once thats out of the way, I will then explore one of the main alternative models to the CAPM that can also be used to determine high risk asset prices, The Fama-French 3 Factor Model, and subsequently discuss why the former is used far more frequently than the latter.

It is essentially an equation which takes in three pieces of information regarding an investment (i); the risk free rate rate (Rf), the sensitivity of the securitys returns to movements in the overall market return, otherwise known as Beta ( ), and the risk premium (ERm Rf) and ultimately returns a single figure; the required or expected return.

Based on this information the equation of the CAPM is as follows, E(i) Rf (ERm Rf).

Capm Vs Sml Plus The Level

In English terms, this means that the return on a specific security is equal to the current risk free rate plus the level of systematic risk proportional to its risk premium.

If you increase or rather the level or market risk, the expected returns on the security increases.

This essentially links back to the general concept mentioned in one of my previous blogs of greater risks lead to greater returns.

Now that a brief theory description of the model has been done, I feel a working example is needed to describe the model effectively.

Therefore, I will now do a simple real-world example of the CAPM with regards to everyones favourite company Apple Inc.

The equation should look as follows, R(i).001.82(.069.001).

Thus we calculate the risk premium to be 6.8 and the overall required or expected rate of return for an apple share to be 5.5.

Looking at the equation and the resulting figure, this required rate of return makes some sense because the beta of.82 suggests that Apple shares carry less risk than the overall market, meaning that a lower return than the markets should be expected.

The CAPM is certainly not infallible; quite the opposite, the CAPM has a number of limitations primarily due to its reliance on unrealistic assumptions.

While Im not going to go into the specifics of these assumptions, I will however highlight some of the criticisms of the model that stem from them.

The first, and possibly the greatest of these criticisms, comes from economists Eugene Fama and Kenneth French (2004).

They go so far as to claim that the CAPM model record is poor, poor enough to invalidate the way it is used in applications, ultimately due to theoretical failings, aka simplified assumptions.

In simple terms, Fama and French highlight a fundamental flaw of the CAPM (Fama French, 2004).

They claim the beta used in the CAPM does not fully account for an assets risk, and that differences in expected returns are not completely explained by differences in beta.

According to them, two other risk factors exist and must be incorporated into an effective asset-pricing model; market capitalisation (aka size) and book-to-market ratio.

They found that the higher average returns on small stocks and high book-to-market stocks reflect unidentified state variables in the CAPM that produce undiversifiable risks in returns that are not captured by the market return and are priced separately from market betas.

Where CAPM identifies beta as the sole risk factor in expected stock returns, this 3-factor model also incorporates two additional risk factors which I highlighted earlier; market capitalisation and book-to-market ratio.

Thus the 3-factor model appears as follows, R(i) Rf B i (Rm Rf) C i (Rsmb) D i (Rhml) where.