Question

There are several "extensions" of the single-factor Capital Asset Pricing model (CAPM) into multi factor models. D escribe 4 such ones. Also describe Roll's critique of the CAPM

Answer 1

CAPM: The Capital Asset Pricing Model describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.

Extensions:

1. Size (SMB) : In this the size factor will be reprsented by SMB. SMB (Small minus Big) accounts for the spread in return between small and large sized firms. This is based on the market capitalisation size of the firms.

2. Value (HML): On eway to measure a Value factor is to use something called the Book- To - Market. This ratio is known for comparing the growth status of companies.

3. Fama-French 3-Factor Model (FF3F): Fama and French followed on from these findings and others and decided to test the relation of stock prices to the factor of Market Capitalisation. Book to Market ratio, Earning to Price Ratio and Leverage along with the amrket.

4. Momentum (UMD) : Up minus Down accounts for the spread in returns between stock with High and Low momentum over the last 2-12 months. It is proposed that stock that have had a positive yearly return will outerperform stocks that have had a negative return over the period for the following 12-months.