Thursday, August 19, 2004

Just in time for class, another CAPM Review :)

Galagedera provides an excellent review of the Capital Asset Pricing Model. From its beginnings (growing out of the work of Markowitz), to its possible demise the paper reviews the history of CAPM without breaking any new ground, but rather assuring that we are all up to speed with what has been done.

Some of the high points:

  1. The review of the existing CAPM literature is excellent and laid out in an easy to follow format. From the Capital Market Line to the work of Sharpe and Lintner, the paper describes the "whys", the "hows", and even the "why nots" of the CAPM.
  2. Unlike most textbooks, the author takes seriously the problems with non-normal returns. For instance:

    "Many researchers investigated the validity of the CAPM in the presence of higher-order co-moments and their effects on asset prices. In particular, the effect of skewness on asset pricing models was investigated extensively. For example, Kraus and Litzenberger (1976), Friend and Westerfield (1980), Sears and Wei (1985) and Faff, Ho and Zhang (1998), among others extended the CAPM to incorporate skewness in asset valuation models and provided mixed
    results....Investors are generally compensated for taking high risk as measured by high systematic variance and systematic kurtosis. Investors also forego the expected returns for taking the benefit of a positively skewed market. It also has been documented that skewness and kurtosis cannot be diversified away by increasing the size of portfolios (Arditti, 1971). "

  3. The author concludes that the assumptions (especially of normality) are important, but even when the problems of assumptions are adjusted for, CAPM still has very mixed results.
  • As a note, given Fama and French's CAPM review (See April's FinanceProfessor Newsletter, and June's FP Blog Archive ), I do feel a bit sorry for Galagedera, but it none-the-less is a very well done article and it is easy enough for upper level undergraduates to grasp with little problem. (Which is a hint to all of my students ;) )


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