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Contemporary Asset Pricing Theories Essay

2440 words - 10 pages

Contemporary asset pricing theories state that the decisive factor of a particular asset’s expected return depends on the non-diversifiable component of risk embodied within it. The main dilemma for asset pricing models simply boils down to the recognition and measurement of the relevant component in the firm-specific risk exercising influence on the expected returns. This essay will examine the recent theoretical developments in this area, focusing mainly on Sharpe and Lintner’s (1964a, 1965b) capital asset pricing model (CAPM). The aim of the essay is to question the validity of the CAPM by elucidating its theoretical and empirical flaws.

Description of the capital asset ...view middle of the document...

Finally, it is also used to estimate the cost of capital that is to be used in the firm’s investment decisions (Brealey, Myers & Marcus, 2009).

Even though the CAPM‘s history is pervaded by intensive polemic - which will be addressed later on - it is still one of the most frequently used financial models for asset pricing both in academic curriculum and in business working life, so why is that? The advantages that the CAPM offer are associated with the simple, powerful and intuitively satisfying predictions about how to measure risk and the relationship between how risk and expected returns are correlated. By applying the CAPM in the estimation of expected returns for all securities, one can use a characteristic line to distinguish patterns. Thus, by doing that one is able to determine if any groups of securities are significantly deviating from what is expected (Kothari, Shanken & Sloan, 1995). A real life example might be useful to illustrate this advantage. Let us consider an observation of merger announcement by 50 firms at different points in time. The characteristic line could be used to establish a measure of expected returns on the announcement day for these companies. By then comparing the actual returns to the estimated returns from the characteristic line we can evaluate the market reaction to the announcement. This methodology can provide information regarding both managerial behaviour and market perceptions - this is called 'event study'. (Chordia, Roll & Subrahmanyam, 2000)

CAPM was developed by Sharpe and Lintner’s (1964a, 1965b) and the model builds on the Portfolio models developed by Harry Markowitz (1959). Both these models were derived from von Neumann and Morgenstern’s (1953) Expected Utility Theory (EUT). Markowitz (1959) Portfolio models state that investors are mean-variance optimisers and that they only are rewarded for carrying systematic risk (i.e. market risk or non-diversifiable risk) and that unique risk (i.e. idiosyncratic or firm-specific risk) is diversifiable - unique risk can be eliminated without adding any cost by distributing the capital over a substantial number of investments. Von Neumann and Morgenstern’s (1953) EUT is an economic, game theory and decision theory developed with the purpose of defining preferences over uncertain outcomes. In short, the theory states that decision makers (e.g. investors) are rational and risk-averse. Beside these inherited rationales Sharpe and Lintner (1964a, 1965b) have made some additional assumptions in their development of the CAPM framework. The CAMP assumes that e.g.; investors hold diversified portfolios, investors can borrow and lend at the risk-free rate of return, a perfect capital market, investors can trade without transaction or taxation costs and that all necessary information is available at the same time to all investors.

Examination of the CAPM’s assumptions
Markowitz (1959), Sharpe and Lintner's (1963) assumption that...

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