Some Concerns about Beta and the CAPM
by MaestriThe Capital Asset Pricing Model (CAPM) is more than just an abstract theory described in textbooks—it is also widely used by analysts, investors, and corporations. However, despite the CAPM’s intuitive appeal, a number of studies have raised concerns about its validity. In particular, a study by Eugene Fama of the University of Chicago and Kenneth French of Yale cast doubt on the CAPM.17 Fama and French found two variables that are consistently related to stock returns: (1) the firm’s size and (2) its market/book ratio. After adjusting for other factors, they found that smaller firms have provided relatively high returns, and that returns are relatively high on stocks with low market/book ratios. At the same time, and contrary to the CAPM, they found no relationship between a stock’s beta and its return.
As an alternative to the traditional CAPM, researchers and practitioners have begun to look to more general multi-beta models that expand on the CAPM and address its shortcomings. The multi-beta model is an attractive generalization of the traditional CAPM model’s insight that market risk, or the risk that cannot be diversified away underlies the pricing of assets. In the multi-beta model, market risk is measured relative to a set of risk factors that determine the behavior of asset returns, whereas the CAPM gauges risk only relative to the market return. It is important to note that the risk factors in the multi-beta model are all nondiversifiable sources of risk. Empirical research investigating the relationship between economic risk factors and security returns is ongoing, but it has discovered several risk factors, including the bond default
premium, the bond term structure premium, and inflation, that affect most securities.
Practitioners and academicians have long recognized the limitations of the CAPM, and they are constantly looking for ways to improve it. The multi-beta model is a potential step in that direction.
Are there any reasons to question the validity of the CAPM? Explain.
Taken From : Five-Minute MBA – Corporate Finance
No related posts.
Related posts brought to you by Yet Another Related Posts Plugin.
