[The performance of CAPM and ABT in the period 1885-1925]

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Introduction

CAPM requires something more than APT to support its prediction that sensitivity to one economic force- the force reflected in the returns to the market portfolio- is the only determinant of expected or required return on an asset. On the other hand, APT views several economic forces as the systematic determinants of actual returns on an asset. The development of the CAPM risk-return relationship is more involved than the APT relationship. But the relationship itself is the same as APT would have if there was only one pervasive economic force influencing the return generation process. CAPM's assumption that sensitivity to the market is the only required indicator of risk, and thus the only determinant of expected or required return, may perhaps be good enough even if APT provides a better description of how markets generate returns. This is because, different sensitivities of each asset to the collection of economic forces could net out, so that sensitivity to a single market index would do as good a job as any multi-factor model in explaining the expected return differences among assets.

Objectives of the study

Following are the objectives of the study for which the proposed study is conducted:

To determine the performance of the CAPM (Capital Asset Pricing Model) in a historical context (1885 - 1925).

To determine the performance of the APT (Asset Price Model) model in a historical context (1885 - 1925).

We will be comparing the performances of these both models.

Research questions

Following are the research questions for the proposed study:

How differently the CAPM and APT models perform in historical index?

How does APT model performs best at pricing the systematic and idiosyncratic risk in monthly stock returns

Is pricing idiosyncratic risk is a significant challenge for many asset pricing models

Significance of the Study

Investors and financial researchers have paid considerable attention during the last few years tothe 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 andin their attempt to assess the risk exposure to different assets.

Literature Review

A number of recent studies examine the importance of idiosyncratic risk in cross-sectional stock returns and the time-series predictability of returns. Much of this research has been spurred by the finding in Campbell, Lettau, Malkiel and Xu (2001) that idiosyncratic risk has increased in U.S. stock returns in recent decades. Angelidis and Tessaromatis (2004) report similar trends in U.K. stock returns. However, Bekaert, Hodrick and Zhang (2005) fail to find a significant trend in idiosyncratic risk in the G7 countries.

Goyal and Santa-Clara (2003), Brown and Ferreria (2004), Angelidis and Tessaromatis (2004) and Bali, Cakici, Yan and Zhang (2005) examine the time-series predictive ability of idiosyncratic risk of future U.S. and U.K. market excess returns. Goyal and Santa-Clara (2003) find that idiosyncratic risk has predictive power of future U.S. excess market returns, but this relation is disputed by Bali, Cakici, ...