The Higher Moments Model

CAPM is used as starting point for the concept of portfolio theory and asset pricing, however despite despite its seductive simplicity, the CAPM's empirical problems probably invalidate its use in applications. (Fama et al 2004) Therefore it is important to examine CAPM’s empirical tests as there have been a substantial number of hypothesis tests developed to test the structure of the CAPM model and also to investigate some of the alternative asset pricing models in comparison of their concepts and validity. Most of these tests have examined the past to determine the extent to which stock returns and betas have corresponded in the manner predicted by the single linear factor, the security market line.

Generally there has been vigorous debate

They aimed to create a model where when market returns are not always normal but sometimes skewed or leptokurtic, that the CAPM is therefore not enough to price equity returns so they recommended the addition of higher moments. (Hasan et al 2014)

These higher moments can be described as additional risks such as skewness and kurtosis. As this model was developed throughout the years by Friend, Westerfield and Dittmar they aimed to prove that skewness and kurtosis were significant in explaining the variable asset returns. They proceeded to examine that the systematic skewness (co-skewness) is capable of explaining the behaviour of asset returns which was before not fully explained by the traditional CAPM. The higher moment models therefore continues to suggest that many investors prefer ‘odd’ moments and are willing to pay a substantially higher price for them and that investors dislike even or safe moments and usually expect to be compensated for them. (O’Brien 2016) This higher moment model demonstrates to us that investors are usually of a more risk-taking nature compared to the traditional CAPM

The question remains is CAPM still used in today’s modern financial markets? I do believe that CAPM and its simplistic nature will form the starting point for many of the future investor decisions. Although CAPM and its assumptions are unrealistic many of its assumptions such as the simplification of reality is necessary to develop useful and newer models. Financial managers may not use CAPM in isolation but can use it to supplement and evaluate other techniques and judgments in an attempt to develop realistic and useful cost of equity calculations. (Mullins