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Finance FHS Tutorial 2 Answers
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Finance FHS Tutorial 2 Answers: CAPM Theory and Practice
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Finance Tutorial 2Question 1
Discuss the weaknesses of the CAPM.
CAPM has consistently failed empirical tests:
When you test CAPM...
o Run time series regression
o Test CAPM by running cross-section regressions:
b ≠ (rm – rf) and a ≠ 0: Firstly, low beta assets' expected returns are underestimated under CAPM,
producing abnormal positive returns (positive alpha). The converse is true for high beta assets.
This manifests itself as a flatter empirical SML line compared to the theoretical SML under
CAPM.
c ≠ 0: Secondly, other factors beyond systematic risk captured in beta appear to predict returns.
These factors are mainly firm characteristics, with higher returns being associated with small
firm size, large book to market value, high profitability, low investment, and high momentum.
This means that CAPM is an ineffective as a tool for cost of equity estimation or performance
measurement (Fama & French, 2004):
CAPM is a poor tool for cost of equity estimation as it underestimates expected return for low
beta stocks and high B/M value stocks
CAPM is also a poor tool for performance measurement, as even passive portfolios with
holdings concentrated in low beta stocks, small stocks, or value stocks produce positive
abnormal returns
These empirical failures can be attributed to CAPM's unrealistic assumptions:
About investors...
o CAPM's assumption of investors having a one-period horizon is unrealistic. Under the
intertemporal CAPM (ICAPM), investors that care about lifetime consumption pay a
premium for assets that hedge nonmarket risks to consumption. Such assets would thus
have lower returns than expected under traditional CAPM.
About capital markets...
o CAPM's assumption of unlimited borrowing and lending at risk-free rate could explain
low beta assets outperforming CAPM expectations. Constrained investors bid up high-
beta assets as they buy more risky securities to compensate for limited leverage access,
so high beta assets underperform, and low beta assets outperform (Frazzini & Pedersen,
2014). A modified model called the 'Zero Beta Model' where agents are leverage-
constrained explains this effect.
o CAPM's assumption that there are no non-financial assets, so all risky assets are publicly
traded, is unrealistic. If we consider that some assets like private business equity or
human capital in the form of future expected labour income are non-tradable or hard-
to-trade assets, then holders of such assets would pay a premium for tradable assets
that hedge against risks to their non-tradable assets. Tradable assets that provide
hedging ability thus have lower returns than expected under CAPM.
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