CAPITAL ASSET PRICING MODEL

Capital Asset Pricing Model

Capital Asset Pricing Model

Abstract

The article examines the Capital Asset Pricing Model (CAPM) for the Greek stock market using weekly stock returns from 2 companies (British Land Co/Prudential) listed on the Athens stock exchange for the period of January 1998 to December 02. In order to diversify away the firm-specific part of returns thereby enhancing the precision of the beta estimates, the securities where grouped into portfolios. The findings of this article are not supportive of the theory's basic statement that higher risk (beta) is associated with higher levels of return.

The model does explain, however, excess returns and thus lends support to the linear structure of the CAPM equation.

I. Introduction

Investors and financial researchers have paid considerable attention during the last few years to the new equity markets that have emerged around the world. This new interest has undoubtedly been spurred by the large, and in some cases extraordinary, returns offered by these markets. Practitioners

all over the world use a plethora of models in their portfolio selection process and in their attempt to assess the risk exposure to different assets. (Graham 2001)

One of the most important developments in modern capital theory is the capital asset pricing model (CAPM) as developed by Sharpe [1964], Lintner [1965] and Mossin [1966]. CAPM suggests that high expected returns are associated with high levels of risk. Simply stated, CAPM postulates that the expected return on an asset above the risk-free rate is linearly related to the non-diversifiable risk as measured by the asset's beta. Although the CAPM has been predominant in empirical work over the past years and is the basis of modern portfolio theory, accumulating research has increasingly cast doubt on its ability to explain the actual movements of asset returns. (Gibbons 1989)

II. Empirical appraisal of the model and competing studies of the model's validity

2.1. Empirical appraisal of CAPM

Since its introduction in early 1960s, CAPM has been one of the most challenging topics in financial economics. Almost any manager who wants to undertake a project must justify his decision partly based on CAPM. The reason is that the model provides the means for a firm to calculate the return that

its investors demand. This model was the first successful attempt to show how to assess the risk of the cash flows of a potential investment project, to estimate the project's cost of capital and the expected rate of return that investors will demand if they are to invest in the project. (Hamilton 1994)

2.2. The classic support of the theory

The model was developed in the early 1960's by Sharpe [1964], Lintner [1965] and Mossin [1966]. In its simple form, the CAPM predicts that the expected return on an asset above the risk-free rate is linearly related to the non-diversifiable risk, which is measured by the asset's beta.

One of the earliest empirical studies that found supportive evidence for CAPM is that of Black, Jensen and Scholes [1972]. Using monthly return data and portfolios rather than individual stocks, Black et al tested whether the ...