Asset Pricing Model

1. Introduction
1.1 CAPM
The Capital Asset Pricing Model which also known as CAPM, developed by William Sharpe (1964, 1965) and John Lintner (1965) along with their partners Jack Treynor (1961, 1962) and Jan Mossin (1966) in the early 1960s, building on the earlier work of another American financial economist Harry Markowitz (1959) on his diversification and modern portfolio theory, hence marks the birth of asset pricing theory. The theory is soon awarded with Nobel Prize for Sharpe in 1990. (French C. W., 2003)

In Markowitz’s model, when an investor chooses a portfolio at time t-1 that it will gives a stochastic return at time t. The models made an assumption of investors are risk averse and when choosing among several of portfolios, they

Nevertheless, the theory that developed by Markowitz is often called a “mean-variance model.”

On the Markowitz’s portfolio model, it provides an algebraic condition on asset weights in mean-variance-efficient portfolios. Later on, CAPM turns this algebraic statement into a testable prediction about the relationship between risks and expected return by first indicating a portfolio must be efficient if asset prices are to clear the market of all assets. Sharpe and Lintner soon added two keys of assumptions to the Markowitz model which is to identify a portfolio that must be mean-variance-efficient. The first assumption is complete agreement: given market clearing asset prices at time t-1, investors agree on the joint distributions of asset returns from time t-1 to time t. And this distribution is the true one-that is, it is the distribution from which the returns we use to test the model are drawn. The second assumption is that there is borrowing and lending at risk-free rate, which is the same for all investors and does not depend on the amount of borrow or lent. (French E. F., 2004). All the assumptions made by Sharpe and Lintner will soon discuss

The Sharpe and Lintner CAPM has never been an empirical success until today. Meanwhile, the Black version of CAPM which can accommodate a flatter tradeoff of average return for market beta managed to show a bigger success compared to the previous version of CAPM. But in the late 1970s, research begins to discover variables like momentum, various price ratios and size that gives an average returns provided by beta. The problems are just enough to invalidate the most application of the