Theory and Evidence - Assignment Example

Introduction The Capital Asset Pricing Model is one of the pre-eminent asset pricing models in financial theory. It is also one of the widely used models on the part of investors and practitioners for the purpose of evaluating risk encompassing an asset. The CAPM theory rests on several assumptions and hypotheses that have made the model highly debatable in the academic realm. Several academicians and scholars have argued on the empirical validity of the CAPM theory and claim that the model has several technical and empirical problems [Fama and French (2004), Michailidis (2006), Ryan (2006), (Soufian, 2001) etc]. There are several criticisms on the empirical effectiveness of the CAPM theory viz. the measurement of beta, estimation of market return, difficulties in accessing market portfolio return, reliance on beta as a risk measure, ex ante distribution and ex post population and other unrealistic assumptions underlying the Capital Asset Pricing Model. The model has seriously failed in terms of empirical tests and several studies refute its acceptability as the best asset pricing model. This paper sheds light on the empirical problems and criticisms of the Capital Asset Pricing Model. It evaluates the points put forward by several scholars and discusses the practical applicability of the model. Empirical Problems in the Capital Asset Pricing Model The Capital Asset Pricing Model theory values an asset with respect to its risk (Soufian, 2001). This risk is measured with the help of beta with respect to the overall market risk. Despite its importance and practical usage, some academics point out several problems that are confronted in the empirical testing and application of the CAPM [Fama and French (2004), Michailidis (2006), Ryan (2006), (Soufian, 2001) etc]. Some of the major points of criticism arise out of the measurability of beta, accessibility of the market portfolios, relationship of beta with market returns and the unrealistic assumptions of the model. These criticisms pose several questions on the practical importance of the Capital Asset Pricing Model. The following paragraphs evaluate the various problems regarding the empirical validity of the CAPM. One of the most important factors underlying the Capital Asset Pricing Model is the measurement of beta which is the covariance between an asset’s return and the market return divided by market return’s variance. Hence, estimation of market portfolio return is an integral element of beta measurement. It is however not clear as to what classes of assets to specifically include or not in the portfolio of market assets. Fama and French propound that “[i]t is not theoretically clear which assets (for example, human capital) can legitimately be excluded from the market portfolio, and data availability substantially limits the assets that are included” (2004, p. 41). Out of different classes of assets, financial and non-financial, which assets to include and which assets to not to include remains to be an important question. This ineffectiveness in dealing with the measurement of market portfolio return delimits the validity and accuracy of beta calculation. Furthermore, a major empirical problem arises in the measurement of beta concerning the length of beta estimation. The model relies on historical data for the estimation of beta whereas there happens to be no specification with regard to the length of period to be used for the estimation. Ryan (2006) suggests that measurement of beta is an important problem that arises in empirical application of CAPM theory. The author doubts the selection of period length vis-à-vis beta such as daily, weekly, monthly, quarterly and yearly. Also in the process of beta measurement for future appraisal, a reliance on historical data leads to complex difficulties. This adds to the empirical complexity of beta estimation and consequently disregards the CAPM theory’s practical validity. CAPM extensively relies on the hypothesis that return of a security depends on its beta or risk. In other words, the risk which is measured with the help of beta determines an asset’s returns. Therefore according to the CAPM theory, high beta or risk should be correlated with high return. However, the empirical evidence does not validate this point. Michailidis (2006) tested the empirical usefulness or validity of the hypothesis put forward by the CAPM theory that high beta or high risk is corresponded with high return encompassing an asset. The study finds empirical evidence against this hypothesis and shows that some portfolios with high beta resulted in negative returns, whereas one portfolio with low beta yielded positive returns. This suggests the invalidity of CAPM in terms of empirical practice. Fama and French also criticise the empirical validity of the hypothesis encompassing the positive relationship between beta and returns of an asset by referring to it as “too flat” (2004, p. 32). The Capital Asset Pricing Model is seriously rejected as an effective pricing model because of the empirical problems in risk and return relationship that constitutes the basis of this theory. The ex ante theory and ex post testing of the model also implicates several empirical problems in its practical usage. The ex ante theory underlying CAPM suggests the relationship between future betas and expected returns. The ex post testing, on the other hand, views the events that have already taken place. As Ryan points out, “[t]here is usually a large difference between investors expectations and the outcomes” (2006, p. ?).The expectations of investors regarding the returns on investment in an asset seldom match with the original outcomes. Hence the CAPM fails to be proved empirically because when in comes to the measurement of risk and return, the assumptions underlying this model are seldom met. It is also one of the assumptions of the CAPM theory that all investors, without any discrepancies, have the same ex ante distribution that they extract returns on investment. It is further assumed that this ex ante distribution necessarily correlates with the ex post population. Ross argues, “…it seems clear that investors do not show homogeneity of beliefs which characterise our theories” (1978, p. 889). This assumption poses great difficulty in terms of empirical testing of the model because of the fact that investors are likely to hold different beliefs concerning the ex ante distribution and ex post population. However because of this assumption, the testers of theories are likely to assume that all investors would share the same ex ante and ex post beliefs which causes the model to fail with respect to empirical validity. Unrealistic assumptions underlying the Capital Asset Pricing Model greatly affect its empirical validity. It is a fact that major empirical and technical problems in the CAPM arise out of the theory’s impractical assumptions and hypotheses. CAPM assumes that an individual asset’s beta or risk should be compared with that of the market whereas it is not proved empirically. Fama and French elaborate that “…market beta is not a complete description of an asset’s risk, and we should not be surprised to find that differences in expected return are not completely explained by differences in beta” (2004, p. 37). Furthermore, in the CAPM theory, it is assumed that investors base their investment decisions only on mean and variance of a portfolio. However, it is questionable in practical terms as investors might be looking for other future opportunities in asset investment. Empirical evidence has also failed to validate this assumption because all investors do not look for mean variance efficiency of a portfolio while making an investment. Another major empirical problem with the Capital Asset Pricing Model is its reliance on one period measurement of asset prices. However, the fact is that most investors purchase assets for longer term investment purposes. Also, the factors that are used in calculation of one period CAPM are also subject to change in the long run such as the risk free rate of return (Ryan, 2006). This one period assumption of the CAPM theory makes it difficult to carry out empirical tests because of the fact it only estimates required return of an asset at one point in time. However, in reality, investors might not invest for one period rather they may opt for a longer term investment. In such cases, other elements of the model i.e. risk free rate of return and market return may change in the longer run. Considering the above staunch criticism concerning the problems confronted in empirical analysis of the CAPM theory. There are several empirical and technical problems in the CAPM application which mainly arise out of the theory’s unrealistic assumptions and practical invalidity. The hypotheses of the CAPM theory have not been justified by the academicians and scholars of financial literature. Fama and French assert that “…the empirical record of the model is poor- poor enough to invalidate the way it is used in applications” (2004, p. 25). Hence the practical application and usability of the model is questionable unless there is sufficient empirical evidence supporting this view. Conclusion The Capital Asset Pricing Model is recognised among investors and practitioners as a reliable estimator of risk and expected return of an asset. It is widely used for the purpose of portfolio diversification. This paper discusses the major criticisms encompassing the empirical validity of the CAPM theory. The difficulties arising in measurement of beta with respect to the estimation of market portfolio return is an important empirical issue. The CAPM theory relies heavily on the positive relationship between an asset’s risk or beta with the expected return, however the empirical tests conducted on the theory outright reject this point. Furthermore, the CAPM theory assumes that there happen to be a strong relationship between ex ante expected returns and ex post outcomes, however in reality the investors’ expectations and returns might vary considerably. The homogeneity of investors’ belief also does not suggest practical applicability of the model. The investors might not share common ex ante distribution and ex post population beliefs. It is also assumed in the CAPM theory that beta is the accurate estimator of risk underlying an asset whereas empirical tests suggest that an asset’s beta may not truly represent its risk. Moreover, investors might not only base their investment decision on mean variance efficiency solely, as assumed by the model. The one period assumption of the CAPM theory also makes it difficult for practitioners to apply the model on practical situations because, in reality, investors might invest for longer periods. All the above criticisms and empirical failures suggest that CAPM has limited practical applicability. Although the model is actively used in various investment decisions, there is less evidence that the model works in practical situations as suggested by empirical evidences. In practice, it is very likely that situations move against the assumptions upon which the application of the CAPM theory rests. References Fama, E.F. and French, K.R. (2004). The Capital Asset Pricing Model: Theory and Evidence, Journal of Economic Perspectives, Summer, 18(3), pp. 25-46 Michailidis, G., Tsopoglou, S., Papanastasiou, D. Mariola, E. (2006). ‘Testing the Capital Asset Pricing Model (CAPM): The Case of the Emerging Greek Securities Market,’ International Research Journal of Finance and Economics, 4, pp. 75-91 Ross, S.A. (1978). ‘The Current Status of the Capital Asset Pricing Model (CAPM),’ The Journal of Finance, 33(3), pp. 885-901 Ryan, B. (2006). ‘Corporate Finance and Valuation.’ Thomson Business Press Soufian, N. (2001). ‘Empirical Content of Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) Across Time Manchester,’ Metropolitan University Business School Working Paper Series, WPS010 Read More