The document summarizes a presentation on the Capital Asset Pricing Model (CAPM). It includes an introduction to CAPM, objectives to understand the relationship between risk and return and validate the CAPM model through literature review. Research questions on whether risk and return are related and if CAPM is valid. The methodology section describes using Markowitz's model, the three-factor model, and regression analysis. While some studies have found issues, the conclusion is that CAPM remains the best option for measuring expected returns though could be improved. Recommendations include using daily data for betas and carefully selecting risk-free rates and market returns.

2. The Capital Asset Pricing Model:
Theory and Evidence.
Course title:
Seminar in Finance
Presenter:
Bilal Shahzad Khan.

3. Table of Contents:
1. Introduction
• Objective
• Research questions
• Hypothesis
2. Problem statement
3. Contribution
4. Literature review
5. Data
6. Variables
7. Methods
8. Analysis
9. Conclusion
10. Recommendation

4. INTRODUCTION:
CAPM:
“A model that describes the relationship between risk and expected return and that is used in the
pricing of risky securities.” -investopedia
The CAPM formula is:
R a = rrf + βa (r m- r rf)
where:
rrf = the rate of return for a risk-free security
rm = the broad market's expected rate of return
β = Beta of the asset

5. OBJECTIVES:
Objectives of this study is to,
 Know relationship between risk and return.
 Validity of CAPM model.
 Proving validity by Literature review of previous studies.

6. RESEARCH QUESTIONS:
Is there any relationship between risk and return?
Is the CAMP model valid and applicable in present time?

7. HYPOTHESIS:
Ho= Market Betas completely explaining the expected return by capturing all kind
of risks.
H1= Market Betas isn’t completely explaining the expected return by capturing all
kind of risks.

8. PROBLEM STATEMENT:
Every investor wants maximum expected return. But this is a
difficult decision to select a security that will give high expected return among all,
when there are various associated uncertain risks. There are possibilities that
expected returns may divert due to beta or market behavior.

9. CONTRIBUTION:
 CAPM model is better in calculating the expected return of individual as well as
portfolio return.
 Investors can easily find the E(R) and also look its future diversified behavior.
 It provides a clear reflection of market risk by its Beta.

10. LITERATURE REVIEW:
CAPM model is now built on Harry Markowitz’s firstly introduced model of portfolio choice in 1959.
Sharpe (1964) and Lintner (1965) predicted that the premium per unit of beta is the expected market return minus
the risk-free interest rate and they added two assumptions
 Complete agreement
 Borrowing and lending at risk free rate
Fisher black (1972) developed a version of the CAPM without risk free borrowing and lending.
Blume, Friend (1970) Jensen & Scholes (1972) work with portfolio individual securities by saying if CAPM explains
security returns it should also explain portfolio returns.

11. LITERATURE REVIEW:
Fama and Macbath (1973) proposed a method for addressing the inference problem caused by correlation of the residual in
cross-section regression. Later in (1993-96) they also introduced Three-Factor Model.
Gibson, Ross and Shanken (1989) provided F-test that gives simple economic interpretation. The estimator then tests whether
the efficient set provided by the combination of this tangency portfolio and the risk-free asset is reliably superior to the one
obtained by combining the risk-free asset with the market proxy alone.
 Merton's (1973) intertemporal capital asset pricing model (ICAPM), for one, is an extension of the CAPM.

12. DATA:
Data base of CRSP ( Center of Research in Security Prices) of the University Of
Chicago was used to check the betas of followings
 NYSE (1928-2003)
 AMEX (1963-2003)
 NASDAQ (1972-2003)

13. VARIABLES:
Beta β:
“Beta is a measure of the volatility, or systematic risk of a security, or a portfolio in comparison to the market as a whole. Beta is used in
the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns. Also
known as "beta coefficient.“ -investopedia
Expected return R:
“The amount one would anticipate receiving on an investment that has various known or expected rates of return. For example, if one
invested in a stock that had a 50% chance of producing a 10% profit and a 50% chance of producing a 5% loss, the expected return would be 2.5% (0.5 *
0.1 + 0.5 * -0.05). It is important to note, however, that the expected return is usually based on historical data and is not guaranteed.” -
investopedia
• Market premium
• Market return
• Covariance
• Variance (residual variance)

14. METHODOLOGY:
1. Markowitz”s Frontier
2. Three-factor model
3. Price Ratio Problem
4. Time series regression
5. Cross section regression
6. F-Test
7. Time return mean variance

15. METHODOLOGY:
Markowitz model:
In Markowitz's model, an investor selects a portfolio
at time t-1 that produces a stock return at t.
in the sense that the portfolios
1) Minimize the variance of portfolio return, given
expected return,
2) Maximize expected return, given variance.
Thus, the Markowitz approach is often
called a "mean variance model."

16. METHODOLOGY:
Fama and French Three-factor Model:
They show that the returns on the stocks of small firms covary more with one another than with returns on the stocks of large firms, and
returns on high book-to-market (value) stocks covary more with one another than with returns on low book-to-market (growth) stocks.
(Three factor model) E(R) – Rƒ = β [ E(Rm – Rƒ)] + β E(SMB) + β (HML)
• SMB, (small minus big) is the difference between the returns on
diversified portfolios of small and big stocks,
• HML (high minus low) is the
difference between the return on diversified portfolios of high and low B/M
stocks.
• The betas are slopes in the multiple regression of R — Rƒ on Rm— Rƒ
SMB and HML.

17. METHODOLOGY:
Price Ratio Problem:
A major problem for the CAPM is that portfolios
formed by sorting stocks on price ratios produce a wide range
of average returns, but the average returns are not positively
related to market betas (Lakonishok, Sbleifer and Vishny, 1994;
Fama and French, 1996, 1998).

18. ANALYSIS:
Various empirical tests were done to check whether it is correct by all means
1) Test on risk Premium:
2 problems were marked after this test
• Estimates of beta for individual assets are inaccurate.
• The regression residuals have common sources of variation
2) Testing whether Market Beta explain Expected Returns:
Beta had explained better the individual security return in early stages than portfolio. Later, tests explained that Beta also
explains the expected returns of both.

19. ANALAYSIS:
3) Recent Tests:
1) When common stocks are sorted on earnings-price ratios, future returns on high E/P stocks are higher than
predicted by the CAPM. -Basu's (1977)
2) A size effect: when stocks are sorted on market capitalization average returns on small stocks are higher than
predicted by the CAPM. -Banz (1981)
3) High debt-equity ratios (book value of debt over the market Value of equity, a measure of leverage) are linked
with returns that are too high relation to their market betas. -Bhandari (1988)
4) Stocks with high book to market equity ratios (B/M, the ratio of the book value of a common stock to its market
value) have high average returns that are not captured by their betas. -Stattnan (1980) and Rosenberg, Reid and Lanstein
(1985)

20. ANALAYSIS:
It is obvious that investor cares about how their portfolio return co varies with future
investment opportunities and labor income. So a portfolio return variance misses important
dimension of risks. If this is true, market beta doesn’t completely represent asset’s risk.
Merton (1973) did extension in CAPM model as ICAPM (Intertemporal Capital Pricing
Model) which helps investor to better consume their payoff with opportunities.

21. CONCLUSION:
 It is stated that so many studies are conducted to disprove CAPM as the standard market pricing theory, yet none of
any proved it inappropriate for estimating return.
 Criticisms are done by presenting different studies and theories. Some of few did nothing but explained CAPM
theoretically better then Sharpe and Lintner.
 Fisher Black’s study got success empirically offering ‘irrational pricing’ and ‘simple discounting rule’ for CAPM’s beta
validity.
 To some extent Jensen’s Alpha can also be used to better measure the abnormal performances. Therefore present
CAPM model is made as sharpe-Lintner-Black model comprehensively.
 As there is no better alternative of CAPM model yet therefore it is better option to measure/estimate expected return.

22. RECOMMENDATIONS:
 For the better usage and reliability of CAPM model, one should use a day-to-day data which
gives more efficient results then month-by-month data.
 Beta should be carefully calculated when we are using it for portfolio investment.
 One should undertake the risk free rate and market return.
 Further work can be done over CAPM model for its alternative or betterment.