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Critically analyse the relative merits of the capital asset pricing model (CAPM) and empirical approaches to asset pricing (such as the Fama and French model) - Essay Example

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Critically analyse the relative merits of the capital asset pricing model (CAPM) and empirical approaches to asset pricing (such as the Fama and French model)

specific risks that it introduced, has become a standard analytical tool among stock investors, even as it continues to be attacked by its detractors.
CAPM decomposes the risk a portfolio carries into two general types: systematic risk, which is the risk of holding the market portfolio, and specific risk, which is the risk unique to each individual asset. Systematic risk represents the variability of the general market movement. All stocks traded in the market are affected, to a greater or less degree, by the general sentiment of the market, and therefore stock prices rise and fall as a group when systematic risk is perceived to be particularly pronounced. On the other hand, specific risk represents that component of the return of an asset that is not correlated with the general movement of the market.
The major difference between the two risks is that specific risk can be diversified away by combining stocks whose specific risks are uncorrelated. Therefore, losses that may be incurred in downtrending stocks at a particular time could be offset by the resiliency of other stocks that are negatively correlated to it. On the other hand, since systematic risk affects all stocks in the market then it could not be minimized through diversification (Contingency Analysis, 2010).
Systematic risk is measured by the beta of the stock, and each individual stock has its beta. The CAPM states that the rate of return that may be expected from investing in a stock is equal to the sum of the risk free rate and the risk premium on the stock, where the risk premium is the product of the beta multiplied by the difference between the risk free rate and the return on the market portfolio. In mathematical form, the CAPM is expressed as:
The risk-free rate is the rate of return on investments that are deemed to have to have no risk, i.e. whose returns are certain. The risk-free rate is generally acknowledged to be represented by the return on fixed-income government ...Show more

Summary

In the 1960s, William Sharpe (1964), Treynor (1961) and Lintner (1965), independently arrived at the development of a model that extended the asset pricing theory of Harry Markowitz, linking the risk and return of stocks. This model is best known as the Capital Asset Pricing…
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Critically analyse the relative merits of the capital asset pricing model (CAPM) and empirical approaches to asset pricing (such as the Fama and French model) essay example
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