Capm vs. Apt: an Empirical Analysis
Yurop Shrestha
Economics Thesis
CAPM vs. APT: An Empirical Analysis
Introduction
The Capital Asset Pricing Model (CAPM), was first developed by William Sharpe (1964), and later extended and clarified by John Lintner (1965) and Fischer Black (1972). Four decades after the birth of this model, CAPM is still accepted as an appropriate technique for evaluating financial assets and retains an important place in both academic scholars and finance practitioners. It is used to estimate cost of capital for firms, evaluating the performance of managed portfolios and also to determine asset prices. Since the inception of this model there have been numerous researches and empirical testing to assess the strength and the validity of the model. Several variations of the models have been developed since then (Wei 1988, Stein, Fama & French 1993, Merton 1973). The Arbitrage Pricing Theory of Capital Asset Pricing formulated by Stephen Ross (1976) and Richard Roll (1980) offers a testable alternative to the CAPM. Both of these asset pricing theories have gone through intense empirical and theoretical scrutiny with multiple researches supporting or refuting both the models. The purpose of this paper is to empirically investigate the two competing theories in light of the US Stock Market in relatively stable economic times.
The first section will look at the logic and theoretical aspects of the competing asset pricing models. The second section analyses and discusses the existing literature and empirical analyses on both the theories. In the third section I explain the data and the testing methods employed to empirically examine the theories. The fourth section explains the results derived from the tests. The last section includes the conclusion and discusses the limits and implications of my research.
SECTION I: CAPM and APT
CAPITAL ASSET PRICING MODEL (CAPM) Sharpe’s (1964) CAPM is built upon the model of portfolio choice by Harry Markowitz (1959). According
Economics Thesis
CAPM vs. APT: An Empirical Analysis
Introduction
The Capital Asset Pricing Model (CAPM), was first developed by William Sharpe (1964), and later extended and clarified by John Lintner (1965) and Fischer Black (1972). Four decades after the birth of this model, CAPM is still accepted as an appropriate technique for evaluating financial assets and retains an important place in both academic scholars and finance practitioners. It is used to estimate cost of capital for firms, evaluating the performance of managed portfolios and also to determine asset prices. Since the inception of this model there have been numerous researches and empirical testing to assess the strength and the validity of the model. Several variations of the models have been developed since then (Wei 1988, Stein, Fama & French 1993, Merton 1973). The Arbitrage Pricing Theory of Capital Asset Pricing formulated by Stephen Ross (1976) and Richard Roll (1980) offers a testable alternative to the CAPM. Both of these asset pricing theories have gone through intense empirical and theoretical scrutiny with multiple researches supporting or refuting both the models. The purpose of this paper is to empirically investigate the two competing theories in light of the US Stock Market in relatively stable economic times.
The first section will look at the logic and theoretical aspects of the competing asset pricing models. The second section analyses and discusses the existing literature and empirical analyses on both the theories. In the third section I explain the data and the testing methods employed to empirically examine the theories. The fourth section explains the results derived from the tests. The last section includes the conclusion and discusses the limits and implications of my research.
SECTION I: CAPM and APT
CAPITAL ASSET PRICING MODEL (CAPM) Sharpe’s (1964) CAPM is built upon the model of portfolio choice by Harry Markowitz (1959). According
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