The Capital Asset Pricing Model (CAPM)

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Theory: Literature Review

One way of summarizing the existing knowledge is to say that asset prices are fundamentally determined by risk, attitudes toward risk, as well as behavioral factors. An extensive summary of the asset-pricing theories, different models and empirical studies are found in The Royal Swedish Academy of Sciences, 2013.

Efficient Market Hypothesis (EMH)

EMH became an important theory in the 1960s. Samuelsson (1965) showed that asset prices in wellfunctioning markets with rational expectations should follow the random walk theory and Fama (1965) provided supportive evidence of the random walk hypothesis. Market efficiency, an essential assumption in the efficient market hypothesis (EMH) formulated by Eugene Fama in 1970, suggests that at any given time, prices fully reflect all available information on a particular stock and/or market and represents the best estimate of intrinsic value. According to the EMH, no investor has an advantage in predicting a return on a stock price because all information that could predict performance is already factored into the stock price, meaning that no one has access to information not already available to everyone else. There is no room for arbitrage.The additional main assumptions of the EMH are that information is universally shared and that stock prices follow a random walk. This means that the asset prices are determined by today´s news rather than yesterday´s trends. In his 1970 paper, Fama included three forms of financial market efficiencies.The strength of these assumptions depends on which particular form of the EMH that is analyzed.The three form types are: weak, semi-strong, and strong form. The weak form of the theory states that all public information is fully reflected in prices and past performance has no relationship to future returns – in other words, trends do not matter. This of course is a very critical view of what stock analysts call “technical analysis”. Certain patterns of prices and other historical data imply, according to these technical analysts, certain future price paths. The weak form of the EMH does however argue that this cannot be done. The semi-strong form of the theory says that stock prices are updated to reflect both market and non-market public information. The strong form of the theory states that all public and private information is fully and immediately factored into asset prices (Burton and Shah,2013) The concept of the EMH has been questioned in the last couple of decades as a result of advances in behavioural finance and also as a result of the success of quantitative trading algorithms, where high frequency trading is an example. Over time it has contributed to market efficiency, indicating that markets were not efficient before. The EMH does not reject the possibility that the market would exhibit such anomalies, but states that the prices will be over- or undervalued at random, which means that they would retract to their mean values.Fama and French (1992) investigated whether there are some regularities/patterns that can offer suggestions to help determine the value of an asset; to make the asset price predictable; using past data to predict the future, which of course is contrary to EMH (Random walk theory).The EMH remains the central concept of financial economics, despite that it is in many cases unsupported by empirical evidence. Its axiomatic definition shows how asset prices would behave under assumed conditions. Testing for this price behavior is questionable as the conditions in the financial markets are much more complex than the simplified conditions of perfect competition, zero transaction costs and free information used in the formulation of the EMH.

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The Capital Asset Pricing Model (CAPM)

The EMH is a general statement arguing that information determines prices, and nobody can predict future stock returns outside the simple idea that risks create reward. To be able to get high returns you have to take great risks (Shah and Burton, 2013). The CAPM is a more specific way of characterizing asset prices than the broad EMH statement. There is a relation between the price of an asset and the risk associated with that asset.The CAPM is a model that explains the relationship between the value (expected return) of a stock and its risks. Stocks with high risk should, on average, earn a higher return than stocks with lower risk. It builds upon work by Harry Markowitz (1952), whose analysis was extended to a general equilibrium setting, known as the Capital Asset Pricing Model (CAPM). The model was independently developed by Sharpe (1964), Lintner (1965) and Mossin (1966). The CAPM is based upon assumptions regarding individual investors and the market structure. It assumes that the investors are rational mean-variance optimizers who have homogenous expectations, and also assumes that the planning horizon is limited to a single period. The market structure is such that all assets are publically held and traded on public exchanges, short positions are allowed, and investors can borrow or lend at common risk-free rates. All information is publically available, where there are no taxes nor transaction costs. The model also assumes that the investor bears two types of risks,namely systematic risks and firm specific risks, where firm specific risks can be diversified away.The CAPM and its assumptions are based on the efficient market hypothesis (EMH) and the validity of utility maximization.

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1. Introduction 
2. Theory: Literature Review
2.1 Efficient Market Hypothesis (EMH) 
2.2 The Capital Asset Pricing Model (CAPM)
2.3 Other theories – Behavioural finance
3. Review of Empirical Studies 
3.1 Previous Swedish studies
4. Data and Methodology 
4.1 Sources of information
4.2 Dependent variables
4.3 Independent variables
4.3.1 Size – Explanatory variable is designed as Small Minus Big (SMB)
4.3.2 Book-to-market ratio (HML)
4.3.3 P/E ratio (LMH)
4.4 Market return
4.5 Risk-free return
4.6 Specifications of models that are estimated
5. Results and Analysis
5.1 CAPM 
5.2 Fama-French three-factor model
5.3 Adding LMH to Fama-French three-factor model
6. Conclusions
6.1 Future research 

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