Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) was developed by harpe, Lintner and Mossin (Dempsey, 2013). The CAPM model states that relevant risk for assets is the only systematic risk because investors can diversify idiosyncratic risk (Bhatnagar & Ramlogan, 2012; Dempsey, 2013). Thus, the expected return on assets risk-free rate as well as the systemic risk determines the expected returns of any asset. An asset’s sensitivity to market is the only measure of systemic risk in CAPM. The fundamental assumption of the CAPM approach is that some stocks are greatly affected by the market fluctuations than others and those that are greatly affected have a greater systemic risk (Dempsey, 2013). Thus, this approach posits that risks depend on an asset’s exposure to macroeconomic events. The sensitivity to an asset stock’s macroeconomic events is measured in comparison to the market referred to as beta.
There is no market risk since a given portfolio is not sensitive to the market when it has a beta of zero. However, a beta of one means that a given asset stock is moving precisely with the market. An asset who beta is greater than one reacts disproportionately with the market while an asset whose beta is less than one reacts less proportionately with to the market. A greater beta means that an asset is associated with a greater systemic risk. Therefore, an asset with a higher beta gives a higher return than the one with a lower beta. There is a positive relationship between an investment’s risk and its return. According to the CAPM model, the relationship between an investment’s risk and its return exists between the beta (systemic risk) and the return (Dempsey, 2013). Thus, security market line (SML) illustrates the CAPM. Security market line (SML) indicates the additional return of an asset given by its systemic risk.
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Fama-French Three-Factor-Model
The Fama-French Three-Factor-Model (TFM) is one of the most prominent models. TFM is based on the Arbitrage Pricing Theory (APT). According to the APT, systematic risk is multidimensional. Thus, the systemic risk depends on various economic risk factors. In comparison to the TFM model, the CAPM only relies on beta as the sensitivity to the market (Bhatnagar & Ramlogan, 2012). However, the TFM model includes two additional factors on top of the beta factor having a direct relationship to the asset’s return. Fama and French (2004) noted that firms having the same beta but different market capitalization had significantly different returns. Also, the asset returns relied on the book-to-market value.
The Best Model
The Three-Factor-Model (TFM) is an approach for asset pricing that expanded the CAPM asset pricing approach by adding risk and size to CAPM’s market risk factor known as the beta. The TFM model takes into consideration the fact that small-cap stock and value regularly outperform markets. Through the introduction of these two factors on top of the risk factor, the TFM asset pricing approach I seen as the most appropriate tool for the evaluation of the manager’s performance (Bhatnagar & Ramlogan, 2012). Also, the TFM model is better than the CAPM approach in creating the understanding of the performance of asset performance, estimating the future returns, portfolio construction, and evaluating the effects of active management (Bhatnagar & Ramlogan, 2012). Thus, it can be argued that the TFM approach has replaced the CAPM as the most appropriate model of explaining the stock prices.
References
Bhatnagar, C. S., & Ramlogan, R. (2012). The capital asset pricing model versus the three factor model: A United Kingdom Perspective. International Journal of Business and Social Research , 2 (1), 51-65.
Dempsey, M. (2013). The capital asset pricing model (CAPM): the history of a failed revolutionary idea in finance?. Abacus , 49 , 7-23.
Fama, E. F., & French, K. R. (2004). The capital asset pricing model: Theory and evidence. Journal of economic perspectives , 18 (3), 25-46.
