CAPM: Theoretical formulation, Empirical evidence and Interpretation

Ing. Glory Ojone Haruna

Master's thesis

Abstract:

The capital asset pricing model (CAPM) is an important model in the field of finance. It is one of the simplest and highly revered models in finance. It explains variations in the rate of return on a security as a function of the rate of return on a portfolio consisting of all publicly traded stocks, which is called the market portfolio. The capital asset pricing model provides a formula that calculates the expected return on a security based on its level of risk. Generally, the rate of return on any investment is measured relative to its opportunity cost, which is the return on a risk-free asset. The resulting difference is called the risk premium, since it is the reward or punishment for making a risky investment. After the CAPM was developed, many empirical tests of the model were conducted using proxies for the different variables. Several of these showed that the CAPM didn't hold in many situations and was often inaccurate or unsuitable in predicting asset values. The aim of the thesis is to analyze the logical theory of CAPM, review the empirical evidence on the shortcomings of CAPM and its interpretation and to determine whether the evidence is enough to dispose the model.

Abstract:

The capital asset pricing model (CAPM) is an important model in the field of finance. It is one of the simplest and highly revered models in finance. It explains variations in the rate of return on a security as a function of the rate of return on a portfolio consisting of all publicly traded stocks, which is called the market portfolio. The capital asset pricing model provides a formula that calculates the expected return on a security based on its level of risk. Generally, the rate of return on any investment is measured relative to its opportunity cost, which is the return on a risk-free asset. The resulting difference is called the risk premium, since it is the reward or punishment for making a risky investment. After the CAPM was developed, many empirical tests of the model were conducted using proxies for the different variables. Several of these showed that the CAPM didn't hold in many situations and was often inaccurate or unsuitable in predicting asset values. The aim of the thesis is to analyze the logical theory of CAPM, review the empirical evidence on the shortcomings of CAPM and its interpretation and to determine whether the evidence is enough to dispose the model.

Keywords

standard CAPM, empirical tests, beta coefficient, market premium, risk-free rate

Language used: English

Date on which the thesis was submitted / produced: 12. 5. 2017

Thesis defence

• Date of defence: 19. 6. 2017
• Supervisor: Ing. Dagmar Linnertová, Ph.D.
• Reader: Ing. Galina Deeva

Masaryk University

Faculty of Economics and Administration

Master programme / field:
Finance and Accounting / Finance (eng.)