PMP/CAPM Prep Workshop Intro and Scope PMP/CAPM Prep Workshop1.
CAPM Recap
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Transcript of CAPM Recap
Intermediate Investments F303 1
CAPM Recap • The expected return on an asset is written as
– E(ri) = Rf + Betai [E(rm) – Rf]
– Beta = Cov (Ri, Rm) / Var (Rm)
• The market is mean-variance efficient
• An asset’s expected return is related to its level of systematic or non-diversifiable risk as represented by Beta
• The excess return on an asset over and above that predicted by CAPM is the asset’s Alpha
• Over time, an assets alpha is expected to be 0
• e, The non-systematic, firm specific variance is also expected to be 0 over time.
Intermediate Investments F303 2
Critiques and Criticisms of CAPM
• Roll’s critique– Identifying the market portfolio
– Are the arguments surrounding CAPM really circular in nature?
– Roll maintains that CAPM is not testable
• Does the existence of Alpha indicate a bad model or market inefficiency?– Recall the example of the Franklin Income Fund, the
DJIA and Salomon’s High Grade Bond Index
– Was the Franklin Funds under-performing alpha the result of a bad model or market inefficiency?
Intermediate Investments F303 3
Stock Return Anomalies
• The small firm effect– Small market cap returns
– January effect
• The liquidity effect– Amihud and Mendelson argue Beta ineffective in
predicting the returns of less liquid assets
• Calendar effects– January effect (again!)
– Day of the week effect
Intermediate Investments F303 4
Stock Return Anomalies (cont)
• The Earnings / Price effect
The CAPM debate has gone in three stages:
1. Support
2. Critique based on Fama and French
3. A return to support
Intermediate Investments F303 5
The CAPM Debate
• Fama and French– Beta not an effective predictor– Prefer firm size and book to market ratios
• Black, Scholes and Jensen– Support for a linear relationship, but there was a
permanent existence for alpha
• Critique of Fama and French– Errors in methods, sample size and sample periods– A survivorship bias
• In the end, beta is still an important factor in predicting returns, it is simply not the only one!