A RESEARCH PROJECT BY: NIDHI SHARMA

ROLL NO.: IM-98-35

COURSE: MMS (5YRS.) – VII SEM.
 AN INTRODUCTION TO
THE CAPITAL ASSET PRICING MODEL

CAPM relates expected return on any asset to market risk. It identifies

two types of risks – the risk associated with the market, in general,
systematic risk, and the risk specific to the company, unsystematic risk.
The investors can eliminate the unsystematic risk by holding a
diversified portfolio. However, the systematic risk cannot be eliminated
even if one holds virtually all stocks. The core idea of CAPM is that
only undiversifiable risk is relevant in the determination of expected
return on any asset. Since the diversifiable risk can be eliminated,
there is no reward for bearing it.

The systematic risk is measured by β − the sensitivity of a security’s

return to market return. These sensitivities differ from security to
security. There are some securities more volatile than the others.
CAPM states that differences in the expected return of any two assets
are because of differences in β (market sensitivity). The securities with
higher (lower) β will offer higher (lower) return.
So the CAPM delivers an expected value for security i's excess return
that is linear in the beta, which is security specific. Statistically, beta
can be interpreted as the individual security's contribution to the
variance of the entire portfolio. The security's risk is referred to its
contribution to the variance of the portfolio's return -- not to the
individual security's variance.

This relation holds for all securities and portfolios. If we are given a
portfolio's beta and the expected excess return on the market, we can
calculate its expected return.

AIM OF THIS RESEARCH

This research studies the anomalies of Capital Asset Pricing Model.

There is a controversy regarding the empirical validity of CAPM. This
research work reviews the content and scope of the model, examines
the issues in the controversy, and provides an empirical assessment of
the model in India.

The question is, should one really believe in CAPM? Does anyone?
Firstly, it does not say anything about the company. It is only some
simple calculations using historical data of market and stock prices.
As Warren Buffett has written, one company might make Barbie dolls
and the other pet rocks; if they have the same beta, then CAPM says
that one is as good as the other.

Secondly, it does not say anything about the

price you pay for the stock. Current stock
prices do not appear in the CAPM. (This is not
quite true. They may have a small effect on the
calculations of the beta.) The reason for this is
that the CAPM depends on the notion that the
market is efficient. “Whatever is the current
price of a stock, this is what you should buy, or
sell, it for. No amount of analysis will enable
you to outperform this strategy”, says EMH, With the Efficient Market
the efficient market hypothesis. Hypothesis, stock prices
are assumed to follow
paths that can be
described by tosses of a
coin.

LITERATURE REVIEW

§ Investing: Managing the Most Important Risks

Author – Paul Merriman
Journal – Journal of Finance, July 2001

§ Stocks Ben Graham Would Buy Today…

Author – Narendra Nathan, Avinash Singh, Clifford Alvares, Vishal
Chhabaria
Journal – Intelligent Investor, January 10, 2001
§ Capital Asset Pricing Model: Should We Stop Using It?
Author – Valeed A Ansari
Journal – Vikalpa, January-March 2000

§ The Cross-section of Expected Return

Author – Fama E and French K
Journal – Journal of Finance, Vol 47 1992

HYPOTHESIS FORMULATION

a) Expected returns on securities are a positive linear function of their

market betas (market sensitivity). The securities with higher (lower) β
will offer higher (lower) return.

b) Market β is adequate to describe the cross section of expected

returns. In other words, beta is the sole determinant of expected
return.
 DATA COLLECTION TECHNIQUES

β is the ratio of the movements of an individual stock relative to the

movements of the overall market portfolio or a proxy such as the
S&P500 index. The portfolio containing all assets in the economy is
called Market Portfolio. This portfolio plays a central role in CAPM.
The market portfolio is unobservable, and therefore, it has to be
proxied by some index like stock market. Technically speaking, β is the
covariance of a stock’s return with the return on a market index scaled
by variance of that index. It is also measured as slope in the regression
of a stock’s return on market. CAPM predicts that risk premium varies
in direct proportion to β.

These returns are plotted for 15 months in the year 1998-1999 for the
S&P500 index and Gillette on the following chart. The thing to notice is
that swings of Gillette are more pronounced than those of the index.
Using this data gives Gillette a beta of 1.37.

The return between expected return and β posited by CAPM can be

stated as

Ri = Rf + (Rm – Rf) bi
Where,
RI = expected return on security i
Rf = risk – free interest rate
Rm = expected rate of return on market portfolio
bI = for security I
Rm – Rf = market risk premium
Or
EXPECTED RETURN = PRICE OF TIME + PRICE OF RISK * AMOUNT
OF RISK

The first expression is the reward for waiting i.e. delaying consumption
without risk. The second expression is the reward per unit of risk
borne. This component is return required due to risk.

Rm – Rf is the reward market offers for bearing average systematic risk

in addition to waiting. The amount of systematic risk present in a
security is presented by β. Thus, the return on any asset is risk-free
rate plus the β multiplied by the market risk premium.

CAPM assumes existence of risk-free asset. CAPM holds that market

does not reward for bearing the risk which investors themselves can
diversify.
CAPM has a variety of applications. The tools of CAPM are helpful not
only for allocation of capital for real investment but also for allocation
of funds for financial investment. CAPM can be used for decisions
concerning capital expenditure, corporate restructuring, financing,
investment, and evaluation of portfolio performance.

THE CURRENT DEBATE

CAPM developed by Sharpe, Lintner and Black predicts –

1. Securities with higher β will have higher expected return and vice
versa.
2. β is the sole determinant of expected return.

In the late 1970s, CAPM came under attack as striking anomalies were
reported. These anomalies underlined the fact that firm characteristics
such as company size (measured by market capitalization of common
stock), the ratio of book-to-market value, price-to-earning ratio, and prior
return performance have more explanatory power than β in explaining
cross-sectional variation in returns. In other words, differences in beta
do not account for differences in return, as the CAPM predicts.
One of the earliest anomalies as reported by Basu (1977) related to
price-earning ratio effect. Firms with low price-earning ratio yielded
higher sample return and firms with higher price-earning ratio
produced lower returns than justified by beta. Banz reported the
empirical contradiction to the SLB model in terms of size effect. He
finds that market capitalization or market equity (ME) (a stock’s price *
shares outstanding) bolsters the explanation of the cross-section of
average returns. Average returns on low ME stocks are too high given
their β estimates and average returns on large stocks are too low.

Fama and French (1992, 1993, 1996) reported that β as a sole

explanatory factor of the sample return is dead. They argued that
portfolios formed on the basis of ratio of book value of equity to
market value and size (market capitalization) earn higher return than
what is predicted by CAPM. Thus, size and book-to-market ratio can
capture the cross-sectional differences in return better than β.
Fama and French (1992) reported two unfavorable conclusions about
the CAPM theory –

1. The univariate relation between β and average return for 50 yrs.

(1941-1990) is weak. Further the relation between β and average
return disappears during the most recent 1963-1990 period, even
when β alone is used to explain average return.
2. β does not capture average returns. Size and book value to market
ratio help explain differences in average returns that are missed by β.

Thus, their findings are at variance with the central prediction of the
SLB model that average stock returns are positively related to market
β. According to them, “variables that have no special standing in asset
pricing theory show reliable power to explain the cross-section of
average return.” They also state that stock risks are multi-dimensional
and one dimension of risk is proxied by size and ME and another by
BE/ME. They favor BE/ME as the relative distress factor.

EXPLANATIONS FOR ANOMALIES IN THE CAPM MODEL

• Data Snooping

Data Snooping biases refer to those in statistical inferences that

result from using information from data to guide subsequent research
with the same or related data. Consequently, a given set of data is
used more than once for drawing inferences or model selection.

Black (1993) observes that a researcher is indulging in data mining

when he tries many ways to do a study including various combinations
of explanatory factors, periods, and models and reports the successful
sequence that advocates his conclusions.

Merton (1987) discusses the problem of data snooping and

warns that researchers may find anomalies because they are too close
to data. The data reuse may induce the possibility that “some
satisfactory results may simply be due to chance rather than to any
merit inherent in the method yielding the results.

Lo and McKinley (1990) illustrate the effect of data snooping biases

in the tests of Sharpe-Lintner version of CAPM by grouping of stocks
into portfolios based on characteristics (e.g. size or price earning
ratio). The grouping of stocks is not guided by theory but by previous
observation of mean stock returns using related data.

Data Snooping biases can be dealt with by verifying whether

similar findings can be obtained using other data covering other
periods or different countries. It offers one explanation of the
deviations from the model.

• Sample Selection Bias

Sample Selection biases can arise, when data availability leads

to certain subsets of stocks being excluded from the analyses. Kothari
(1995) argues that since failing stocks (excluded from the sample)
would be expected to have low returns and high book market ratios,
the average return of the included high book-market ratio stocks would
have an upward bias. They assert that selection bias in the
construction of book-to-market portfolio could be the cause of
premium reported by Fama and French.

However, Chan (1995) says that selection bias is not large.

Cohen and Polk (1996) form portfolios that are completely free of
selection bias and report identical evidence.

Barber and Lyon (1997) examine the issue by including financial

firms, which were excluded by Fama and French from their analysis
and find results that confirm their conclusions.

The above results demonstrate that selection bias does not

dramatically affect the conclusion of Fama and French. Rather, it has
highlighted that researchers must take cognizance of the sample
selection bias.

• Behavioral Factors

Lakonishok investigated the role of behavioral factors in

explaining anomalies. They argue that superior returns on value stocks
(stocks with low P/E ratio or low market value-to-book value ratios,
glamour [growth] stocks are converse of it) are due to expectational
error made by investors. Investors have a proclivity to extrapolate past
growth too far into the future. They suggest various possibilities that
can explain these differences in average returns :
 § Investors may have a tendency to invest in “good” companies
with high level of profitability and superior management. In the
eyes of unsophisticated investors, a “good” company may be
synonymous with investment irrespective of the price and even
view such stocks to be less risky.
§ Sophisticated institutional investors may tilt their portfolios
towards well-known glamour stocks because they can easily
justify it to their clients. This may push up the prices of these
stocks and lower the expected return.

The development in behavioral economics seeking to understand the

influence of human behavior and psychology in the determination of
stock prices in the financial market has greatly enriched
understanding of drivers of stock returns. Thus, behavioral explanation
has the potential to capture what is not capturable by β.

EMPIRICAL TESTS TO TEST CAPM

The data used is on Franklin Income Fund and some other popular
portfolios in the United States. The returns over the past 15 years
were:

The Franklin Income Fund 516%

Dow Jones Industrial Average 384%
Salomon's High Grade Bond Index 273%

Converting these returns into average annual returns:

The Franklin Income Fund 12.9%

Dow Jones Industrial Average 11.1%
Salomon's High Grade Bond Index 9.2%

The average annual returns are not nearly as impressive as the total
return over 15 years. This is due to the compounding of the returns –
the present value is calculated.

In order to use the CAPM, we need some extra data. We need the
expected return on the market portfolio, the security or portfolio betas
and the risk free rate. Suppose that the average return on the market
portfolio is 13% and the risk free return is 7%. Furthermore, suppose
the betas of the portfolios are:

The Franklin Income Fund 1.000

Dow Jones Industrial Average 0.683
Salomon's High Grade Bond Index 0.367

These are reasonable beta estimates. The Dow is composed of 30 blue

chip securities that are generally less risky than the market. The beta
of the market is 1.00. Any security that has a beta greater than 1.00 is
said to have extra market risk (extra-market covariance). The long-term
bond portfolio has a very low market risk. If we had a short-term bond
portfolio, it would have even lower market risk (beta would probably be
0.10). I have assumed that the beta of Franklin is slightly larger than
the market. The Franklin Growth Fund probably has a beta that is much
higher because growth stocks are usually small and have higher
market risk. Income stocks are usually larger and have market risk
about equal to the market or lower.

Now let's calculate the expected excess returns on each of these

portfolios using the CAPM.

The Franklin Income Fund 13.0% = 7% + 1.000 x (13% - 7%)

Dow Jones Industrial Average 11.1% = 7% + 0.683 x (13% - 7%)
Salomon's High Grade Bond Index 9.2% = 7% + 0.367 x (13% - 7%)

The expected returns for the Dow and the Salomon Bonds were exactly
what the actual average returns were. Note also that the expected
return on the Franklin Income Fund was higher than what was realized.
The market expected 13% performance and the Fund delivered 12.9%.
The difference between the expected performance and the actual is
called the abnormal return. The abnormal return is often used in
performance evaluation.

So now we have a powerful tool with which to calculate expected

returns for securities and portfolios. We can go beyond examination of
historical returns and determine what the risk adjusted expected return
for the security is.

The Security Market Line

Consider the Security Market Line (SML), which relates expected

returns on assets to their non-diversifiable risks -- or their beta.
The Security Market line can also be written in terms of excess
returns.
These graphs help understand the beta functionality better and the
relation between the variables is made easier to understand.

FINDINGS
The CAPM comes out of two things: Markowitz, who showed how to
create an efficient frontier, and James Tobin, who in a 1958 paper said
if you hold risky securities and are able to borrow—buying stocks on
margin—or lend—buying risk-free assets— and you do so at the same
rate, then the efficient frontier is a single portfolio of risky securities
plus borrowing and lending, and that dominates any other
combination.

Tobin's Separation Theorem says you can separate the problem into
first finding that optimal combination of risky securities and then
deciding whether to lend or borrow, depending on your attitude toward
risk. It then showed that if there's only one portfolio plus borrowing
and lending, it's got to be the market.

Both the CAPM and index funds come from that. You can't beat the
average; net of costs, the returns for the average active manager are
going to be worse. You don't have to do that efficient frontier stuff. If
markets were perfectly efficient, you'd buy the market and then use
borrowing and lending to the extent you can. Once you get into
different investment horizons, there are many complications. This is a
very simple setting. You get a nice, clean result. The basic
philosophical results carry through in the more complex settings,
although the results aren't quite as simple.

All empiricists tend to exaggerate the importance of their particular

empirical study. There are different time periods, different markets,
and different countries. You don't always get the same thing. Fama
and French are looking at the question using historical manifestations
of these ex-ante constructs, can confirm that expected returns are
related to beta and/or related to book-to-price and/or related to size.
Given what they did and how they did it—using realized average
returns, which are not expected returns—they found a stronger
empirical correlation with book-to-price and with size than to their
measure of historic beta.

The size effect and the value/growth effect had been written about
before, so neither of these phenomena were new What was new was
that Fama and French got that very strong result at least for the period
they looked at—which, by the way, included the mid-1970s, a very
good period for value stocks, which really drove up those results.
There's a whole industry of turning out papers showing things "wrong"
and "partially wrong" with the Fama- French study. Sharpe points out
that during the period when Fama and French conducted their tests in
the United States, value stocks did much better than growth. He says
in an interview to Dow Jones Asset Manager, May/June 1998 that, “In the
bear market of 1973 and 1974, people thought the world was coming
to an end. The stocks that had been beaten down came back, and they
came back a lot more than some of the growth stocks.

Maybe in an efficient market, small stocks would do better because

they're illiquid, and people demand a premium for illiquidity That gets
to be less compelling if you start thinking about mutual funds that
package a bunch of small stocks and therefore make the illiquid liquid.
As people figured that out, they'd put money into those funds, which
would drive up the price of small stocks, and there goes the premium.
For the value/growth effect, there's the behaviorist story that people
overextrapolate. I have quite a bit of sympathy with that. I'm a bit of a
fan of behavioral finance—the psychology of markets—so I don't
dismiss that argument out of hand.

Since the studies about the size effect were published, small stocks
have not done better than large stocks on average. Since the publicity
about the value effect, value stocks haven't done as well as before
around the world. So there's always the possibility that whatever these
things were may have gone away, and that the publication of these
studies may have helped them go away. It's too early to tell. It's a short
data period.”

CONCLUSION

The evaluation of these studies questions the sufficiency of evidence to

bury beta. It is difficult to take a definitive stand on this issue in view of
the inconclusive nature of debate. Pronouncing the death of beta will
be premature.

Fama and French do not provide a theory and only conjecture that
return premia can be captured by a factor model. Their argument
against beta suffers from any supporting theory to justify choice of
factors. Also, the period when the tests were conducted favoured the
conclusion so derived.

Hence, I would like to conclude that beta does help in making

important investment decisions. CAPM not only survives, but is still
the most preferred tool in corporate finance.

FURTHER AREAS OF RESEARCH

Another related issue is whether returns are indeed based on risk or

whether some other behavioural factor unrelated to risk is at work in
return-generating process. Lastly, if returns are indeed driven by
characteristics and a characteristics-based model is correct in
explaining returns, then it will bring about a totally different
perspective to corporate finance.
REFERNCES

§ www.sherlockinvesting.com
§ www.stanford.edu
§ www.economictimes.com
§ Campbell Harvey’s homepage

BIBLIOGRAPHY

§ ECONOMETRICS - P.N.GUJRATI

§ FINANCIAL MANAGEMENT – I.M.PANDEY

§ C.A MODULE PAPERS – 2000-2001