Monday 28 May 2007

CAPM tests

Many tests have been carried out to determine if the CAPM holds. CAPM postulates that beta completely captures the cross-sectional variation of expected returns. Now, I am not convinced that this simple relationship can help to predict asset returns, and is evidenced by the many test results over the past few decades. Presence of irrational investors and other risk factors must be involved. Hence I wouldn't be interested in doing a test (but which I did several years back). What is surprising is the paper by Fama & French (1992, 1993), that including book-to-market and size as factors can in fact explain asset return variation better. It is also quite robust to different time periods. So much so as this is taken as the industry benchmark in comparing investment portfolios. But how do we intepret BM and size as risk factors? And are there other missing factors?

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