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!