CAPM

Validity of Capital Asset Pricing Model

Validity of Capital Asset Pricing Model

Introduction

The traditional capital assets pricing model (CAPM), always the most widespread model of the financial theory, was prone to harsh criticisms not only by the academicians but also by experts in finance. Indeed, in the last few decades an enormous body of empirical researches has gathered evidences against the model. These evidences tackle directly the model's assumptions and suggest the dead of the beta (Fama and French, 1992, 427-465); the systematic risk of the CAPM.

If the world does not obey to the model's predictions, it is maybe because the model needs some improvements. It is maybe because also the world is wrong, or that some shares are not perfectly priced. Perhaps and most notably the parameters that determine the prices are not observed such as information or even the returns' distribution. Of course, the theory, the evidence and even the unexplained movements have all been subject to much debate. But the cumulative effect has been to put a new look on asset pricing. Financial Researchers have provided both theory and evidence which suggest from where the deviations of securities' prices from fundamentals are likely to come, and why could not be explained by the traditional CAPM.

Understanding security valuation is a parsimonious as well as a lucrative end in its self. Nevertheless, research on valuation has many additional benefits. Among them, the crucial and relatively neglected issues have to do with the real consequences of the model's failure. How are securities priced? What are the pricing factors and when? Once it is recognized that the model's failure has tangible consequences, critical issues arise. For instance the conception of an adequate pricing model that accounts for all the missing aspects. The purpose of this paper is to evaluate the validity of CAPM in measuring risk and the relationship between risk and expected return with reference to the empirical evidence of CAPM.

Discussion

The CAPM developed by Sharpe (1964, 425-472) and John Lintner (1965, 13-37) gave birth to assets' valuation theories. For a long time, this model had always been the theoretical base of the financial assets valuation, the estimate of the cost of capital, and evaluation of portfolios' performance. Being a theory, the CAPM found the welcome thanks to its circumspect elegance and its concept of good sense which supposes that the risk-averse investors would require a higher return to compensate for supporting higher risk. It seems that a more pragmatic approach carries out to conclude than there are enough limits resulting from the empirical tests of the CAPM. In fact, since the CAPM is based on simplifying assumptions, it will be completely normal that the deviation from these assumptions generates, ineluctably, imperfections.

The most austere critic that was addressed to the CAPM, is that advanced by Roll (1977, 129-176). In fact, in his paper, the author declares that the theory is not testable unless the market portfolio includes all assets in the market with the adequate ...