Question

A variety of empirical testing of the Capital Asset Pricing Model (CAPM) has resulted
in the model being described as ‘fatally flawed’ for a number of reasons. Its predictions
about security returns do not always hold true in reality. As a result, alternative models
of the CAPM have been developed. These include the Three Factor Model, Arbitrage
Pricing Theory and the Inter temporal CAPM (ICAPM).

a) Critically discuss the flaws or weaknesses identified by research of the CAPM.

b) Briefly compare the following three alternative pricing models with the CAPM:
i. Three Factor Model
ii. Arbitrage Pricing Theory
iii. ICAPM.

Answer 1

a) CAPM Model is reliant on the Formula that requires inputs of risk free return of an asset, beta for volatility, expected return. Result vary depending on the inputs we'd give. This means the CAPM Model is reliant on the mentioned inputs which can vary the expected result in many different ways which tells us that there is no consistent or perfect result to this. One of the observed flaw in the existing CAPM Research. To discuss further, when we input the value of Risk Free rate, we'd generally inclined to pick short term government securities yield as a benchmark, but this value keeps changing daily hence the accuracy cannot be promised over here. Reliability is little less in this model and this can be viewed a weakness of the model.

Coming to the assumptions, the flawed research of CAPM assumption can be seen when it says the investor has to make a decision only based upon risk-return assessment. This doesn't fulfill an entire case of buying/holding/selling an investment as there are many other factors to consider an investment decision. Also there is another assumption that says that risk free assets can be witnessed whereas in reality it is nearly zero/rare an occurrence. Investors make same kind of decision also comes up in one of the assumptions which is also flawed in the model's assumption.

b) In comparison with CAPM Model, the Fama French Three Factor model considers some more variables such as excess return, size of the differences in between smaller and larger stocks and it's returns, book to market factor. These three inputs make the model stronger than the CAPM Model. CAPM Model only considers the importance of returns and market.

In comparison with CAPM Model, APT considers the macroeconomic factors as it's input of it's model. CAPM looks only after fewer rigid factors like market return and beta, but to determine APT one needs to consider the specific factor like macroeconomic or company specific factors.

In comparison with domestic CAPM Model, International CAPM model considers PPP (Purchasing Power of Parity) and international capital markets.