The Prevailing Capital Asset Pricing Model

6342 Words26 Pages

1. Introduction
The prevailing capital asset pricing model (CAPM, 1964) distinguishes two kinds of risks concerning an asset:
1) Systematic risk, which reveals an asset’s sensitivity to changes in current market conditions and signifies the exposure to market developments by the well-known factor beta.
2) Unsystematic, firm-specific or so-called “idiosyncratic” risk, which is inherent to the firm and its operations.

While systematic risk can nowadays be explained in a statistically straightforward and well-known manner according to the CAPM, idiosyncratic risk and its impact on stock returns has recently become a focus of empirical, financial research. The CAPM, which is based on Markowitz’ portfolio theory, predicts that investors can avoid …show more content…

discovered that extreme (5-1) quintile portfolios ranked according to idiosyncratic volatilities exhibit an average monthly return differential of – 1.31 % in 23 developed markets implying that their newfound effect is of international nature and challenging the famous Fama-French Model. Apart from that, the negative relation is even found to be strongly statistically significant for all G7 countries constituting the largest equity markets. Furthermore, they figure out that there is a remarkable co-movement in international and U.S. extreme quintile return differences. They thus argue that this would imply systematic factors to be analyzed in years to come explaining the unusually high demand for stocks with high idiosyncratic volatility (cf. Ang et al., 2009, …show more content…

(2009, 6-9) found γ coefficients, representing the relation of past idiosyncratic volatility and future monthly returns, for all G7 countries to be strongly negative and statistically significant. Compared with the other factor loadings and firm characteristics such as those by Fama and French being often insignificant, the lagged volatility effect is much more vital. As the Fama-MacBeth regressions are independent from previous measuring shortcomings, for instance creating value-weighted portfolios, the 2009 results are much more robust and suggest a compelling need for a fundamental economic theory explaining them. An appalling characteristic to be additionally noted is that the U.S. idiosyncratic volatility puzzle is most pronounced across the study’s observations. Whereas Europe and Asia exhibit Fama-MacBeth coefficients of – 0.67 and – 1.18 respectively, the U.S. coefficient is an outstanding – 2.01 (cf. Tables 2 and 3). Although the γ coefficient rises from -1.54 to – 0.60 for the entire world and without the U.S. respectively, all those coefficients are statistically significant indicating a robustness of the observed puzzle. Contrasting Bali and Cakici’s argumentation, Ang et al. (2009, p. 8) allege that using Fama-MacBeth regressions instead of value-weighted portfolios would result in additional noise due to its inherent nature in small stocks. Their analysis beforehand was comparable to forming equal-weighted portfolios as it gave large and small stocks

More about The Prevailing Capital Asset Pricing Model

Open Document