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Arbitrage Pricing Theory

From reading the literature review you should be aware that more authors criticise the CAPM than appraise it. The CAPM can be criticised for the same reason as all economic models as it is formed on unrealistic assumptions, this was even acknowledged by its creator Sharpe (1964) although he believes it still has predictive power in its calculation. This power has been said to have differing effects over time, this was identified by: Fama and McBeth (1973), Roll (1977), Reinganum (1981), Bos and Newbold (1984) and Lakonishok and Shapiro (1986).

“Black, Jenson, and Scholes (1972) and Fama and MacBeth (1973) find…there is a positive simple relation between average return and market b during the early years (1926-1968)… Like Reinganum (1981) and Lakonishok and Shapiro (1986), we find that this simple relation between b and average return disappears during the more recent 1963-1990 period”(Fama, 1992, p449). It has been argued by Chen, Roll and Ross (1986) and Fama and French (1992) that beta has little effect on the return of shares and portfolios. Although Roll (1998) noted the beta explains around 40% of returns and this could be seen as good, Roll (1977) has previously said that the CAPM doesn’t work if

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the market used is inefficient.

Sciubba (2006) prefers the other methods that are available for asset pricing. Clare, Priestley and Thomas (1998) prefer the CAPM to the Fama-French model as they have proven it to be a powerful tool for the UK stock market. Graham and Harvey (2001) have discovered that more firms, brokers and investment advisors use or offer the CAPM than any other technique. Alternatives to CAPM Since the CAPM was first developed a number of alternatives have been constructed, two models have attracted more attention, and these are arbitrage pricing theory and the Fama-French three factor model.

Arbitrage Pricing Theory (APT) which is a mere extension of the CAPM was developed by Ross (1976) and is a more complex to calculate than the CAPM as it identifies other areas that affect risk such as oil prices and inflation. “Empirical work on the APT suggests that between two and five factors are linked to stock returns, but interpreting these factors can be tricky”(Gitman, 2007, p234-5). A study conducted by Chen, Roll and Ross (1986) suggested that macroeconomic variables such as changes in industrial production and changes in inflation have greater effect on the stock returns than the market as a whole does.

The Fama-French three factor Model was developed by Fama and French (1992) in an effort to overcome their criticisms of the CAPM. The Fama-French model tries to explain why some stocks earn higher returns than others. “They make two key points in attacking the CAPM and presenting an alternative. The first point is two factors, the size of a firm and the ratio of the book value to its equity to its market value, are systematically related to returns”(Gitman, 2007, p235).

The second point is that similar to Chen, Roll and Ross (1986) they believe beta has little or no impact on returns, in this case after allowing for firm size and market-tobook ratio. “What really distinguishes the Fama-French approach from both the CAPM and the APT is that it is an entirely empirical attempt to model asset prices”(Gitman, 2007, p236). The model is based on the knowledge of Fama-French on the area of asset pricing, such as they believe that smaller firms are riskier than larger ones. Conclusion There has been mixed empirical findings on the return-beta relationship of the capital asset pricing model.

Fama-French (1992) have even developed their own model to eradicate the problems with the CAPM, but even this has problems. Problems with Fama French It has been shown that the Fama-French model isn’t much better than CAPM at predicting returns and only increases the explanation by a couple of percent. Since authors in general believe that CAPM isn’t good at its job the same can be implied to the Fama and French model. Some critics have argued that a low-book-to-market value used in the Fama-French model doesn’t mean a company should automatically be classed as low risk.

This is because in the 1990’s when new internet companies were appearing all the time, these would have came under this classification but as a new company should in fact be classed as a high risk. The CAPM The single-factor CAPM is rejected when the portfolio used as a market proxy is inefficient Roll (1977). As this is an unlikely event, the CAPM has been proven to work. Clare, Priestley and Thomas (1998) suggest that from their study on UK stock returns the CAPM has a significant and powerful tool (b) to explain expected-returns.

As Beta is thought to be unstable over time by authors such as Bos and Newbold (1984) it has been suggested by Sciubba (2006) that investors who continue to implement the CAPM will fail, as there are other methods of asset pricing which do the job better. Pollok (2007) agrees with this statement as he suggests that the Fama- French model is better at predicting than the market but doesn’t explain every aspect; he also suggests that an investor with great knowledge can outperform any capital asset pricing model.

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