In Parts One and Two of our examination of the Capital Asset Pricing Model (CAPM), we evaluated two major assumptions:
1) Market returns are properly modeled by a normal distribution
2) Beta (systematic risk) is the sole source of priced risk for an asset or portfolio of asset
As you recall, we found several weaknesses in both assumptions as they may apply to hedge funds. This time, we’ll examine the remaining assumptions underlying CAPM, and see if each is reasonable when applied to hedge fund trading.
We left off last time showing how the Security Characteristic Line indicates the beta of an asset under Harry Markowitz’s Modern Portfolio Theory (MPT). We are now ready to discuss asset pricing models, and we’ll begin by documenting the Capital Asset Pricing Model (CAPM). This model was developed in the 1960’s by several independent researchers, including Sharpe, Treynor, Lintner and Mossin, building on Markowitz’s previous work.
CAPM is an equation that indicates the required rate of return (ROR) one should demand for holding a risky asset as part of a diversified portfolio, based on the asset’s beta. If CAPM indicates a rate of return that is different from that predicted using other criteria (such as P/E ratios or stock charts), then one should, in theory, buy or sell the asset depending on the relationship of the different estimates. For instance, if stock charting indicates that the ROR on Asset A should be 13% but CAPM estimates only a 9% ROR, one should sell or short the asset, which cumulatively should drive the price of Asset A down. Continue reading “Capital Asset Pricing Model, Part One – Normal Distribution” »