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Critically analyse the relative merits of the Capital Asset Pricing Model and empirical approaches to Asset pricing (such as FAMA and French model) - Assignment Example

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The research paper has been designed to throw a light on the relative merits of Capital Asset Pricing Model (CAPM) in determining the return for an investor that helps him to take investment related decision. The paper also emphasises on the few flaws of the model and thus…
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Critically analyse the relative merits of the Capital Asset Pricing Model and empirical approaches to Asset pricing (such as FAMA and French model)
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Critically analyse the relative merits of the Capital Asset Pricing Model and empirical approaches to Asset pricing (such as FAMA and French model)

Download file to see previous pages... The basic essence of the model is that it determines the amount of return that an investor is going to earn for putting their money at risk.
It would be helpful to have a brief and basic idea about the concept of CAPM with the intention that the understanding of relative merits of it becomes easy. According to the model and ultimate derivation, it can be said that the return which an investor expects to earn by investing on a security or a portfolio is the rate on a risk-free security and a risk premium. The formula for this finding is written like:
The basic concept behind the above model is that the investors are required to be compensated in two ways: risk and time value of money. The compensation for time value of money is represented by the risk-free rate which an investor earns by putting his money on investment over a period of time. The other part of the formula on the right hand side is a factor of risk and it determines the compensation the investors should get for taking an additional amount of risk. This amount is calculated by a risk measure (beta). There are certain implications of the model:
According to Michailidis (2006), an examination of the emerging Greek Securities market was done based on the CAPM by considering weekly stock returns of 100 companies that were listed on the Athens Stock Exchange for the period 1998-2002. The findings of the test did not support the basic statement that higher risk (beta) means higher levels of return. However the model explains excess return and ultimately supports the linear structure of the CAPM equation (Michailidis & Et. Al., 2006).
The model considers reality in explaining risk factor where it assumes only systematic risk associated with the investment options. The unsystematic risk can be removed since there are diversified options for investors and thus can be eliminated.
CAPM derives a theoretical relationship between return and ...Download file to see next pagesRead More
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