UNIT TITLE:
CORPORATE FINANCIAL MANAGEMENT
(5K6Z0046_2223_9)
UNIT LEADER: GRAEME ELGIN
WORD COUNT: 1951
, The Capital Asset Pricing Model (CAPM) produced by Nobel prize winner Sharp (1964) and
Litner (1965) has been of great use to the financial world of academia and practitioners
(Sharp,1964; Litner,1965; Fama & French,2014). The use of the word great is often meant
pejoratively, however. Realistically, CAPM’s effectiveness is far from great, with some
academics even denouncing it with sly insults: Montier’s (2007) abbreviation of completely
redundant asset pricing (CRAP) (Montier,2007); and Fernandez’s (2014) accusation that it is,
in reality, not a factual model, but an ‘absurd’ opinion (Fernandez, 2014). With such polarising
statements, a lot of value can be obtained within the discussion of CAPM, its downfalls, and
its surprising usefulness within academia. This essay will critically evaluate the validity of
Montier’s assertion with the use of empirical studies and reviews from academics of both
sides, analysing where the CAPM lies in the modern finance world.
Broadly speaking, the CAPM is a very alluring mode (Blume, 1992), which aims to condense
the extremely complicated interactions between a firm’s returns within a market and its
underlying forces (Lakonishok et al,1994) , and investor (human) behaviour through risk
evaluation and tolerances (Fama and French,2004). If the model empirically produced even
marginally consistent results(within an allowed amount of error), it would seem to save
analysts an immense amount of time and resources when evaluating portfolios. This is due to
the assumptions it makes around the values used when calculating, and if such complicated
factors could be reduced in complexity using these assumptions there would be no
controversy around the CAPM. Some academics rightfully defend the model since some value
can be drawn from its defence(Levy,2010). The overwhelming weight of empirical evidence
should point to an apparent defeat for the CAPM however, interestingly, it is still widely
taught and utilised to this day(Fernandez 2014;Roll,1977), which indicates there is something
more going on. This essay will look at the three main assumptions where the CAPM is
criticized and critically evaluate the model through the lens of theory, it will also identify
precisely where CAPM lies in the field of finance, hopefully dispelling any confusion caused
by the more polarising and divisive literature from some academics discussed within the
essay.
One compelling piece of evidence against the CAPM is the questioning of investor behaviour
and the criticism of investors being ‘efficient’. Investors have been studied to behave
imperfectly and sometimes irrationally when risk is involved. This breakthrough led to the
breakdown of the CAPM by attacking one of its underlying principles of expected utility theory
(EUT) where investor behaviour couldn’t be explained (Kahneman and Tversky,1979).
Interestingly, this makes sense considering real-world markets as a whole have been
identified as imperfect (Garibaldi,2006), where markets include many individual investors
under risk. However, Levy (2010) highlights, using Tversky and Kahneman’s (1992) Nobel
prize-winning Cumulative prospect theory, we can modify the CAPM to work experimentally
(Levy,2010; Tversky and Kahneman,1992), Levy relies on his own cited studies being correct,
however. Broadly speaking, investors tend to employ weights in their decision instead of
probabilities, where they tend to weigh loss heavier than gain (Hogan and Warren,1974). This
weighting does not hold up when using historical data in the CAPM, the modification
however, includes using forecasted data which actually agrees with the CAPM (Levy,2010)
but, obviously true future data isn’t available without a time machine, which is why this only
works experimentally.
