Intermediate Investments F3031 CAPM Recap The expected return on an asset is written as –E(r i ) = R f + Beta i [E(r m ) – R f ] –Beta = Cov (R i, R m ) / Var (R m ) The market is mean-variance efficient An asset’s expected return is related to its level of systematic or non-diversifiable risk as represented by Beta The excess return on an asset over and above that predicted by CAPM is the asset’s Alpha Over time, an assets alpha is expected to be 0 e, The non-systematic, firm specific variance is also expected to be 0 over time.

Intermediate Investments F3032 Critiques and Criticisms of CAPM Roll’s critique –Identifying the market portfolio –Are the arguments surrounding CAPM really circular in nature? –Roll maintains that CAPM is not testable Does the existence of Alpha indicate a bad model or market inefficiency? –Recall the example of the Franklin Income Fund, the DJIA and Salomon’s High Grade Bond Index –Was the Franklin Funds under-performing alpha the result of a bad model or market inefficiency?

Intermediate Investments F3033 Stock Return Anomalies The small firm effect –Small market cap returns –January effect The liquidity effect –Amihud and Mendelson argue Beta ineffective in predicting the returns of less liquid assets Calendar effects –January effect (again!) –Day of the week effect

Intermediate Investments F3034 Stock Return Anomalies (cont) The Earnings / Price effect The CAPM debate has gone in three stages: 1.Support 2.Critique based on Fama and French 3.A return to support

Intermediate Investments F3035 The CAPM Debate Fama and French –Beta not an effective predictor –Prefer firm size and book to market ratios Black, Scholes and Jensen –Support for a linear relationship, but there was a permanent existence for alpha Critique of Fama and French –Errors in methods, sample size and sample periods –A survivorship bias In the end, beta is still an important factor in predicting returns, it is simply not the only one!