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Capm: Theory, Empirical Evidence and Interpretation Masaryk University Faculty of Economics and Administration Field of study: Finance CAPM: THEORY, EMPIRICAL EVIDENCE AND INTERPRETATION Diploma work Thesis Supervisor: Author: Ing. Dagmar LINNERTOVÁ, Ph.D. Glory Ojone HARUNA Brno, 2017 MASARYK UNIVERSITY Faculty of Economics and Administration MASTER’S THESIS DESCRIPTION Academic year: 2016/2017 Student: Glory Ojone Haruna Field of Study: Finance (eng.) Title of the thesis/dissertation: CAPM: Theoretical formulation, Empirical evidence and Interpre- tation Title of the thesis in English: CAPM: Theoretical formulation, Empirical evidence and Interpre- tation Thesis objective, procedure and methods used: 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 valid on current markets. Process of Work: 1. Introduction and formulation of aims 2. Theoretical framework for CAPM 3. Analysis of the empirical evidence and its interpretation 4. Analysis of findings, formulation of recommendations 5. Conclusion and discussion Methods: analysis, comparison, deduction Extent of graphics-related work: According to thesis supervisor’s instructions Extent of thesis without supplements: 60 – 80 pages Literature: DA, Z, Ruiru GUO and R JAGANNATHAN. CAPM for Estimating the Cost of Equity Capital: Interpreting the Empirical Evidence. , 2009. FAMA, E and K FRENCH. The Capital Asset Pricing Model: Theory and Evidence.. , 2004, roč. 18, č. 3, s. 25–46. ZHANG, W. The Empirical CAPM: Estimation and Implications for the Regulatory Cost of Capital. , 2008, roč. 103, s. 204–220. PENNACCHI, George Gaetano. Theory of asset pricing. Boston: Pear- son/Addison Wesley, 2008. xvii, 457. ISBN 9780321127204. Thesis supervisor: Ing. Dagmar Linnertová, Ph.D. Thesis supervisor’s department: Department of Finance Page 1 of 2 Thesis assignment date: 2016/05/09 The deadline for the submission of Master’s thesis and uploading it into IS can be found in the academic year calendar. In Brno, date: 2017/05/12 Page 2 of 2 Name and surname of the author: Glory Ojone Haruna Title of the diploma thesis: CAPM: Theory, Empirical Evidence and Interpretation Department: Finance Head of the diploma thesis: Ing. Dagmar Linnertová, Ph.D. Year of defense: 2017 Annotation: This diploma thesis is devoted to the Capital Asset Pricing Model, its theory and the evidences against it. The first part introduction is an analysis of the theoretical framework of the CAPM. This is done by looking closely at the standard CAPM, how it is derived and its components. This is followed by an overview of other variations of and alternatives to the CAPM. The next section examines the empirical evidence against the CAPM, the basis for the evidence and their interpretations by critiques. The final section analyses the findings of the researcher and formulates recommendations based on these finding. And in conclusion, the writer discusses whether the evidence is sufficient to discard the CAPM. Keywords: standard CAPM, empirical tests, beta coefficient, market premium, risk-free rate. Statement I hereby declare that I worked out the Diploma work CAPM: Theory, Empirical Evidence and Interpretation myself, under the supervision of Ing. Dagmar Linnertová, Ph.D, and that I stated in it all the literary resources and other specialist sources used according to legislation, internal regulations of Masaryk University and internal management acts of Masaryk University and the Faculty of Economics and Administration. In Brno on 12. 5. 2017 Signature of the author Acknowledgment I would like to thank Ing. Dagmar Linnertová, Ph.D, for her unwavering support, patience and collegiality, which contributed to the success of this diploma thesis. Table of Contents Introduction ............................................................................................................................ 13 1. The Standard capital asset pricing model ....................................................................... 16 1.1 The theory of portfolio choice ....................................................................................... 16 1.2 The classic CAPM: theory and logic ......................................................................... 17 1.2.1 Assumptions of the model……………………………………….…………….. 17 1.2.1.1 Investors are risk averse……………………………………..…..…... 18 1.2.1.2 Homogeneity of expectations ………………………..……………… 18 1.2.1.3 Risk-free lending and borrowing…………………………………….. 19 1.2.2 Development of the Sharpe-Lintner model ……………..…………………….. 21 1.2.3 The security market line ……………………………………………….……… 28 2. Alternate asset pricing models ......................................................................................... 30 2.1 Black “zero-beta” CAPM ……………………………………………..……………. 30 2.2 Consumption capital asset pricing model (C-CAPM) ………………….………….. 34 2.2.1 Key Assumptions……………………………………………………...………. 35 2.3 Arbitrage pricing theory (APT) …………………………………………..………… 37 2.3.1 Assumptions of the model ………………………………………………...……38 2.4 The three factor model ……………………………………………………………… 41 2.5 Intertemporal capital asset pricing model (I-CAPM) ……………………………….. 43 3. Criticisms, tests and the empirical evidence ……………………………………..……. 46 3.1 Roll’s (1977) critique of tests of asset pricing theory ………………………………. 46 3.2 Mayur Agrawal, Debabrata Mohapatra, and Ilya Pollak (2012) …………...………. 48 3.3 Philip Brown and Terry Walter (2013) …………………………………………….. 50 3.4 Ahmad Alqisie and Talal Alqurran (2016) ……………………………..…….……. 53 3.5 Others tests and criticisms ………………………………………………………..… 55 3.5.1 Black, Jensen and Scholes (1972) …………………………………………... 56 3.5.2 Fama and MacBeth (1973) ……………………………………….…………. 56 3.5.3 Banz (1981) …………………………………………….…………………… 57 3.5.4 Blume and Husic (1973) ………….……………………………..………...… 57 3.5.5 Basu (1977) ……………………………………………………..…………… 58 3.5.6 Fama and French (1992) ………………………………………..…...…….… 58 3.5.7 Kothari, S., Shanken, J., & Sloan G. (1995) ………………………………… 59 3.5.8 Jagannathan and Wang (1996) …………………………….……….……..…. 59 3.5.9 Choudhary and Choudhary (2010) ………………………………………….. 59 3.5.10 Bilgin and Basti (2011, 2014) …………………………………......……….. 60 4. CAPM and the current economy ………………………………………………..……. 63 4.1 CAPM and low/negative interest rates ……………...…………………………… 63 4.2 Current opinions on the CAPM ……………………………………….…………. 65 Conclusion ………………………………………………………….…………………….. 80 Bibliography ……………………………………………………….…………………….. 83 List of Figures ..…………………………………………………….…………………….. 87 List of Figures ..…………………………………………………….…………………….. 87 INTRODUCTION 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. The foundation of this model is seen in the portfolio choice model, especially as developed at the beginning of the 1950s by Harry Markowitz. Later, in the middle of the 60s, Sharpe, Lintner and Mossin adapted the basic idea of Markowitz by generalizing the individual decision problem of a single investor to all capital market participants. This step led to the CAPM and other asset pricing models (Wilhelm, 2001, p. 66-67). Accordingly, the CAPM builds upon the model of portfolio choice. The paper, "Portfolio Selection" by Harry Markowitz, established the idea of diversifying a portfolio of stocks in order to produce the maximum potential returns given the amount of risk an investor is prepared to undertake. And a few years later, William Sharpe, John Lintner, and Jan Mossin developed the CAPM in a series of articles. As mentioned above, the Capital Asset Pricing Model (CAPM) laid the basis for modelling the risk-return relationship as it is considered “the basic theory that links risk and return for all assets.” (Gitman, 2006, p. 246) The Capital Asset Pricing Model, which was developed in the mid 1960's, uses various assumptions about markets and investor behaviour to give a set of equilibrium conditions that allow us to predict the return of an asset for its level of systematic (or non-diversifiable) risk. The CAPM uses a measure of systematic risk that can be compared with other assets in the market. Using this measure of risk can, in theory, allow investors to improve their portfolios and managers to find their required rate of return. The capital asset pricing model (CAPM) builds on the Markowitz mean–variance-efficiency model in which risk-averse investors with a one-period horizon care only about expected returns and risk. These investors choose only efficient portfolios with minimum variance, given expected return, and maximum expected return, given variance. Expected returns and variance 13 plot a parabola, and points above its global minimum identify a mean–variance-efficient frontier of risky assets. Thus, the Sharpe–Lintner CAPM theory converts the mean–variance model into a market- clearing asset-pricing model. All investors agree on the distributions of returns and may borrow or lend without limit at a risk-free
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