Review of capital

asset pricing
models
821
Managerial Finance
Vol. 33 No. 10, 2007
pp. 821-832
#Emerald Group Publishing Limited
0307-4358
DOI 10.1108/03074350710779269
A review of capital asset
pricing models
Don U.A. Galagedera
Department of Econometrics and Business Statistics,
Monash University, Caulfield East, Australia
Abstract
Purpose The main aspect of security analysis is its valuation through a relationship between the
security return and the associated risk. The purpose of this paper is to review the traditional capital
asset pricing model (CAPM) and its variants adopted in empirical investigations of asset pricing.
Design/methodology/approach Pricing models are discussed under five categories: the single-
factor model, multifactor models, CAPM with higher order systematic co-moments, CAPM
conditional on market movements and time-varying volatility models.
Findings The paper finds that the last half-century has witnessed the proliferation of empirical
studies testing on the validity of the CAPM. A growing number of studies find that the cross-asset
variation in expected returns cannot be explained by the systematic risk alone. Therefore a variety of
models have been developed to predict asset returns.
Research limitations/implications There is no consensus in the literature as to what a suitable
measure of risk is, and consequently, as to what is a suitable measure for evaluating risk-adjusted
performance. So the quest for robust asset pricing models continues.
Originality/value From its beginning to its possible demise the paper reviews the history of the
CAPM assuring that we are all up to speed with what has been done.
Keywords Capital asset pricing model, Securities, Financial risk
Paper type Research paper
1. Introduction
The foundations for the development of asset pricing models were laid by Markowitz
(1952) and Tobin (1958). Early theories suggested that the risk of an individual security
is the standard deviation of its returns a measure of return volatility. Thus, the larger
the standard deviation of security returns the greater the risk. An investors main
concern, however, is the risk of his/her total wealth made up of a collection of securities,
the portfolio. Markowitz (1952) observed that (i) when two risky assets are combined,
their standard deviations are not additive, provided the returns from the two assets are
not perfectly positively correlated and (ii) when a portfolio of risky assets is formed, the
standard deviation risk of the portfolio is less than the sum of the standard deviations
of its constituents. Markowitz was the first to develop a specific measure of portfolio
risk and to derive the expected return and risk of a portfolio. The Markowitz model
generates the efficient frontier of portfolios and the investors are expected to select a
portfolio, which is most appropriate for them, from the efficient set of portfolios
available to them. Tobin (1958) suggested a course of action to identify the appropriate
portfolios among the efficient set.
The computation of risk reduction as proposed by Markowitz is tedious. Sharpe
(1964) developed a computationally efficient method, the single index model, where the
return on an individual security is related to the return on a common index. The
common index may be any variable thought to be the dominant influence on stock
returns and need not be a stock index (Jones, 1991). The single index model can be
extended to portfolios as well. This is possible because the expected return on a
portfolio is a weighted average of the expected returns on individual securities.
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When analysing the risk of an individual security, however, the individual security
risk must be considered in relation to other securities in the portfolio. In particular,
the risk of an individual security must be measured in terms of the extent to which it
adds risk to the investors portfolio. Thus, a securitys contribution to the portfolio risk
is different fromthe risk of the individual security.
Investors face two kinds of risks, namely, diversifiable (unsystematic) and non-
diversifiable (systematic). Unsystematic risk is the component of the portfolio risk that
can be eliminated by increasing the portfolio size, the reason being that risks that are
specific to an individual security such as business or financial risk can be eliminated
by constructing a well-diversified portfolio. Systematic risk is associated with overall
movements in the general market or economy and therefore is often referred to as the
market risk. The market risk is the component of the total risk that cannot be
eliminated through portfolio diversification.
The CAPM developed by Sharpe (1964) and Lintner (1965) relates the expected rate
of return of an individual security to a measure of its systematic risk. The capital asset
pricing model (CAPM) has become an important tool in finance for assessment of cost
of capital, portfolio performance, portfolio diversification, valuing investments and
choosing portfolio strategy among others. The last half-century has witnessed the
proliferation of empirical studies testing on the validity of the CAPM. A growing
number of studies found that the cross-asset variation in expected returns could not be
explained by the systematic risk alone. Therefore, a variety of models have been
developed to predict asset returns.
This paper is organised as follows. The next section provides a brief description of
two fundamental relationships associated with the CAPM. This followed by a
discussion on the traditional CAPM and its variants employed in empirical studies.
The final section concludes the paper.
2. The capital-asset pricing model
The CAPM conveys the notion that securities are priced so that the expected returns
will compensate investors for the expected risks. There are two fundamental
relationships: the capital market line (CML) and the security market line (SML). These
two models are the building blocks for deriving the CAPM.
2.1 Capital market line
The CML specifies the return an individual investor expects to receive on a portfolio.
This is a linear relationship between risk and return on efficient portfolios that can be
written as:
ER
p
R
f
o
p
ER
m
R
f
o
m
!
1
where R
p
is portfolio return, R
f
risk-free asset return, R
m
market portfolio return, o
p
standard deviation of portfolio returns and o
m
is standard deviation of market
portfolio returns.
According to (1), the expected return on a portfolio can be thought of as a sum of the
return for delaying consumption and a premium for bearing the risk inherent in the
portfolio. The CML is valid only for efficient portfolios and expresses investors
behaviour regarding the market portfolio and their own investment portfolios.
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823
2.2 Security market line
The SML expresses the return an individual investor can expect in terms of a risk-free
rate and the relative risk of a security or portfolio. The SML with respect to security i
can be written as:
ER
i
R
f
u
im
ER
m
R
f
f g 2
where
u
im

o
i
r
im
o
m

covR
i
. R
m

o
2
m
3
and r
im
the correlation between security return, R
i
, and market portfolio return. The
u
im
can be interpreted as the amount of non-diversifiable risk inherent in the security
relative to the risk of the market portfolio. Equation (2) is the SharpeLintner version of
the CAPM. The set of assumptions[1] sufficient to derive the CAPM version of (2) are
the following:
.
the investors utility functions are either quadratic or normal,
.
all diversifiable risks are eliminated, and
.
the market portfolio and the risk-free asset dominate the opportunity set of risky
assets.
The SML is applicable to portfolios as well. Therefore, SML can be used in portfolio
analysis to test whether securities are fairly priced, or not.
3. Empirical issues
3.1 Single-factor CAPM
In order to test the validity of the CAPM researchers, always test the SML given in (2).
The CAPM is a single-period ex ante model. However, since the ex ante returns are
unobservable, researchers rely on realised returns. So the empirical question arises: Do
the past security returns conformto the CAPM?
The beta in such an investigation is usually obtained by estimating the security
characteristic line (SCL) that relates the excess return on security i to the excess return
on some efficient market index at time t. The ex post SCL can be written as:
R
it
R
ft
j
i
b
im
R
mt
R
ft

it
4
where j
i
is the constant return earned in each period and b
im
is an estimate of u
im
in the
SML (Jensen, 1968). The estimated u
im
is then used as the explanatory variable in the
following cross-sectional equation:
R
it

0

1
b
im
u
it
5
to test for a positive risk return trade-off. The coefficient
0
is the expected return of a
zero beta portfolio, expected to be the same as the risk-free rate, and
1
is the market
price of risk (market risk premium), which is significantly different from zero and
positive in order to support the validity of the CAPM. When testing the CAPM using
(4) and (5), we are actually testing the following issues: (i) b
im
s are true estimates of
historical u
im
s, (ii) the market portfolio used in empirical studies is the appropriate
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proxy for the efficient market portfolio for measuring historical risk premium and (iii)
the CAPMspecification is correct (Radcliffe, 1987).
Early studies (Lintner, 1965; Douglas, 1969) on CAPM were primarily based on
individual security returns. Their empirical results were discouraging. Miller and
Scholes (1972) highlighted some statistical problems encountered when using individual
securities in testing the validity of the CAPM. Most studies subsequently overcame this
problem by using portfolio returns. Black et al. (1972), in their study of all the stocks of
the NewYork Stock Exchange over the period 1931-1965, formed portfolios and reported
a linear relationship between the average excess portfolio return and the beta, and for
beta >1 (<1) the intercept tends to be negative (positive). Therefore, they developed a
zero-beta version of the CAPM model where the intercept term is allowed to change in
each period. Extending the Black et al. (1972) Fama and MacBeth (1973) provided
evidence (i) of a larger intercept term than the risk-free rate, (ii) that the linear
relationship between the average return and the beta holds and (iii) that the linear
relationship holds well when the data covers a long time period. Subsequent studies,
however, provide weak empirical evidence on these relationships (see, for example, Fama
and French, 1992; He and Ng, 1994; Davis, 1994; Miles and Timmermann, 1996).
The mixed empirical findings on the returnbeta relationship prompted a number of
responses:
.
The single-factor CAPM is rejected when the portfolio used as a market proxy is
inefficient (See[2], for example, Roll, 1977; Ross, 1977). Even very small
deviations from efficiency can produce an insignificant relationship between risk
and expected returns (Roll and Ross, 1994; Kandel and Stambaugh, 1995).
.
Kothari et al. (1995) highlighted the survivorship bias in the data used to test the
validity of the asset pricing model specifications.
.
Beta is unstable over time (see, for example, Bos and Newbold, 1984); Faff et al.,
1992; Brooks et al., 1994; Faff and Brooks, 1998).
.
There are several model specification issues: For example, (i) Kim (1995) and
Amihud et al. (1993) argued that errors-in-the-variables problem impact on the
empirical research, (ii) Kan and Zhang (1999) focused on a time-varying risk
premium, (iii) Jagannathan and Wang (1996) showed that specifying a broader
market portfolio can affect the results and (iv) Clare et al. (1998) argued that
failing to take into account possible correlations between idiosyncratic returns
may have an impact on the results.
3.2 Multifactor models
A growing number of studies found that the cross-sectional variation in average security
returns cannot be explained by the market beta alone, and showed that fundamental
variables such as size (Banz, 1981), ratio of book-to-market value (Rosenberg et al., 1985;
Chan et al., 1991), macroeconomic variables and the price to earnings ratio (Basu, 1983)
account for a sizeable portion of the cross-sectional variation in expected returns.
Fama and French (1995) observed that the two non-market risk factors SMB (the
difference between the return on a portfolio of small stocks and the return on a
portfolio of large stocks) and HML (the difference between the return on a portfolio of
high-book-to-market stocks and the return on a portfolio of low-book-to-market
stocks) are useful factors when explaining a cross-section of equity returns. Chung et al.
(2001) observed that, as higher order systematic co-moments are included in the
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cross-sectional regressions for portfolio returns, the SMB and HML generally become
insignificant. Therefore, they argued that SMB and HML are good proxies for higher
order co-moments. Ferson and Harvey (1999) claimed that many multifactor model
specifications are rejected because they ignore conditioning information.
Another possibility is to construct multifactor arbitrage pricing theory (APT)
models introduced by Ross (1976). The idea here is to allow more than one measure of
systematic risk. APTmodels allow for priced factors that are orthogonal to the market
return and do not require that all investors are meanvariance optimisers, as in the
CAPM. Groenewold and Fraser (1997) examined the validity of these models for
Australian data and compared the performance of the empirical version of the APT
and the CAPM. They concluded that APToutperforms the CAPM in terms of within-
sample explanatory power.
3.3 CAPM with higher order co-moments
It is clear from well-established stylised facts that the unconditional security return
distribution is not normal (see, for example, Ane and Geman, 2000; Chung et al., 2001)
and the mean and variance of returns alone are insufficient to characterise the return
distribution completely. This has led researchers to pay attention to the third moment
skewness[3] and the fourth moment kurtosis.
It is argued that investors are generally compensated for taking high risk as
measured by high systematic variance and systematic kurtosis and are willing to
forego the expected returns for taking the benefit of a positively skewed market. It has
also been documented that skewness and kurtosis cannot be diversified away by
increasing the size of portfolios (Arditti, 1971).
Many researchers investigated the validity of the CAPM in the presence of higher
order co-moments and their effects on asset prices. In particular, the effect of skewness
on asset pricing models was investigated extensively. For example, Kraus and
Litzenberger (1976), Friend and Westerfield (1980), Sears and Wei (1985) and Faff et al.
(1998), among others, extended the CAPM to incorporate skewness in asset valuation
models and provided mixed results.
Harvey and Siddique (2000) examined an extended CAPM, including systematic co-
skewness. Their model incorporates conditional skewness. The extended form of
CAPM is preferred as the conditional skewness captures asymmetry in risk, in
particular downside risk[4], which has recently become considerably important in
measuring value at risk. Harvey and Siddique reported that conditional skewness
explains the cross-sectional variation of expected returns across assets and is
significant even when factors based on size and book-to-market values are included.
A few studies have shown that non-diversified skewness and kurtosis play an
important role in determining security valuations. Fang and Lai (1997) derived a four-
moment CAPM and it was shown that systematic variance, systematic skewness and
systematic kurtosis contribute to the risk premiumof an asset. See, also, Christie-David
and Chaudhry (2001) who show that the third and fourth moments explain the return-
generating process in the futures markets well.
3.4 CAPM conditional on market movements
Following the suggestion made by Levy (1974) to compute separate betas for bull and
bear markets, Fabozzi and Francis (1977) were the first to formally estimate and test
the stability of betas over the bull and bear markets. They found no evidence
supporting beta instability. However, in an empirical analysis of the cross-sectional
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relationship between the expected returns and beta, Fabozzi and Francis (1978)
concluded that investors like to receive a positive premium for accepting downside
risk, while a negative premium was associated with the up market beta, suggesting
that downside risk as measured by the beta corresponding to the bear market may
be a more appropriate measure of portfolio risk than the conventional single beta.
Prompted by Fabozzi and Francis (1978), several studies tested for randomness of
beta. Kim and Zumwalt (1979) extended the FabozziFrancis design to analyse the
variation of returns on security and portfolios in up and down markets. They used
three alternative measures to determine what constituted an up and down market. Up
market constituted those months in which the market return exceeded (i) the mean
market return, (ii) the mean risk-free rate or (iii) zero. Kim and Zumwalt concluded that
downside risk might be a more appropriate measure of portfolio risk than the
conventional single beta. Chen (1982) allowed beta to be nonstationary in an
examination of the riskreturn relationship in the up and down markets and concluded
that (i) under the condition of either constant or changing beta, investors seek
compensation for assuming downside risk and (ii) as in the study of Kim and Zumwalt
(1979), the down market beta is a more appropriate measure of portfolio risk than the
single beta. Bhardwaj and Brooks (1993) observed that the systematic risks in bull and
bear time periods are statistically different. Their classification of bull and bear
markets is based on whether the market return exceeds the median market return or
not. Studies have considered three-beta models as well. For example, Faff and Brooks
(1998) argued that there is no reason to believe that beta is constant, especially over
long estimation periods, and defined three regimes relating to two major past events.
Ferson and Harvey (1991), on the other hand, in their study of US stocks and bond
returns, revealed that the time variation in the premium for beta risk is more important
than the changes in the betas themselves. This is because equity risk premiums were
found to vary with market conditions and business cycles. Schwert (1989) attributed
differential risk premia between up and down markets to varying systematic risk over
the business cycle.
Pettengill et al. (1995) highlighted that the weak and intertemporally inconsistent
results of the studies testing for a systematic relation between return and beta are due
to the conditional nature of the relation between the beta and the realised return. They
argued that when realised returns are used, the relation between the beta and the
expected return is conditional on the excess market return. They postulated a positive
(negative) relation between the beta and returns during an up (down) market. Their
study of US stocks sampled over the period 1926-1990 reported the existence of a
systematic conditional relation between the beta and the return for the total sample
period, as well as across sub-sample periods.
Following Pettengill et al. (1995) and Crombez and Vander Vennet (2000) analysed
the conditional relationship between stock returns and beta on the Brussels Stock
Exchange over the period 1990-1996. They observed that the beta factor is a strong and
consistent indicator of both upward potential in bull markets and downside risk in bear
markets. Hence investors could improve the performance of their portfolios by using
up and down market betas in their asset selection practice. Crombez and Vander
Vennet found the results to be robust for various definitions[5] of beta and different
specifications [6] of up and down markets.
Galagedera and Silvapulle (2003) adopted the Pettengill et al. (1995) approach to
investigate an extended CAPM with higher order co-moments. Postulating that the
systematic risks corresponding to variance, skewness and kurtosis are different for up
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827
and down markets, Galagedera and Silvapulle examined the relationship between the
returns and higher order systematic co-moments in the up and down markets. They
found strong empirical evidence to suggest that in the presence of skewness in the
market returns distribution, the expected excess rate of return is related not only to
beta but also to systematic co-skewness.
An alternative approach to capture market movements is through various market
volatility regimes. Galagedera and Faff (2005) investigated whether the riskreturn
relation varies, depending on changing market volatility and up/down market
conditions. Having modelled the market return volatility as a time-varying process,
they defined three volatility regimes low, neutral and high based on the level of
conditional volatility. They extended the market model allowing for these three market
regimes and developed a three-beta asset pricing model. Even though their results
overwhelmingly suggest that the betas in the three volatility regimes are positive and
significant, most of the portfolio betas were found to be not significantly different.
3.5 CAPM and time-varying volatility
Since the introduction of ARCH/GARCH[7]-type processes by Engle (1982) and others,
testing for, and modelling of, time-varying volatility (variance/covariance) of stock
market returns (and hence the time-varying beta) have been given considerable
attention in the literature. See Bollerslev et al. (1988) the first study to model the beta
in terms of time-varying variance/covariance and the survey paper by Bollerslev
et al. (1994). The ARCH-based empirical models appear to provide stronger evidence,
though not convincingly, of the riskreturn relationship than do the unconditional
models.
Using monthly data from the UK market from 1975 to 1996, Fraser et al. (2000)
compared the cross-sectional riskreturn relationship obtained with an unconditional
specification of the assets betas with betas obtained through quantitative threshold
ARCH (QTARCH[8]) and GARCH-M[9] models. In all specifications, they allowed for
possible negative returnrisk relationships when excess return on the market is
negative. Fraser et al. observed that CAPM holds better in downward moving markets
than in upward markets and suggested that beta as a risk measure is more appropriate
in the bear markets. They observed that the QTARCH specification, in which they
allowed for asymmetries in the first and second moments of returns, yields a
significant beta without having to account for up and down markets.
Several studies investigated the effect of good and bad news (leverage effects), as
measured by positive and negative returns on beta (see, for example, Braun et al. 1995
(BNS hereafter); Cho and Engle 1999 (CE hereafter) and the references therein). BNS
investigated the variability of beta[10] using bivariate exponential GARCH (EGARCH
[11]) models allowing market volatility, portfolio-specific volatility and beta to respond
asymmetrically to positive and negative market and portfolio returns. CE, on the other
hand, used a two-beta model with an EGARCH variance specification and daily stock
returns of individual firms and concluded that news asymmetrically affects the betas.
The BNS study that used monthly data on portfolios did not uncover this relationship.
4. Concluding remarks
For the CAPM to hold, normality of returns is a crucial assumption, and if the CAPM
holds, then only the beta should be priced. Several studies have shown that security
returns are non-normal and this is evident especially in high-frequency data. When
returns are normal, the mean and the variance are sufficient to describe the return
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distribution. On the other hand, an adequate description of a non-normal return
distribution requires statements on higher-order moments such as skewness and
kurtosis. Prompted by the mixed results of the single-factor CAPM studies and the
non-normal nature of return distribution, the CAPM with higher order co-moments
was proposed in the literature as an alternative to the single-factor CAPM.
Because of the failure of market beta alone to explain cross-sectional variation in
security returns, multifactor models emerged. These models incorporate fundamental
variables such as size and price-to-earnings ratio in addition to the market beta.
It is argued that the studies on the beta and cross-sectional returns relationship that
use realised return as a proxy for the expected return might produce biased results due
to the aggregation of positive and negative market returns. One way of accounting for
market movements is to postulate an inverse relationship between the beta and
portfolio returns in the down market where the market return in excess of the risk-free
return is negative. The studies that adopted such conditional models to test the risk
return relationship reported stronger results than they would obtain otherwise.
Another method of incorporating market movements in capital asset pricing is to allow
variation in the conditional market volatility.
Owing to its intuitive appeal, the CAPM has become an important tool in finance for
assessment of cost of capital, portfolio performance, portfolio diversification, valuing
investments and choosing portfolio strategy among others. However, there is no
consensus in the literature as to what a suitable measure of risk is, and consequently, as
to what is a suitable measure for evaluating risk-adjusted performance. So the quest
for robust asset pricing models continues.
Notes
1. See Sinclair (1987) for a description of these assumptions.
2. Also see Fama and MacBeth (1973), Black (1993) and Chan and Lakonishok (1993) and
the references therein.
3. Early studies examined the empirical relation of ex post returns to total skewness (see,
for example, Arditti, 1967). Subsequent studies argued that systematic skewness is more
relevant to market valuation rather than total skewness (see, for example, Kraus and
Litzenberger, 1976) refuting the usefulness of quadratic utility as a basis for positive
valuation theory. The experimental evidence that most individuals have concave utility
displaying absolute risk aversion also supports inclusion of higher order co-moments in
riskreturn analysis (see, for example Gordon et al., 1972).
4. Downside risk is the risk of loss or underperformance that is considered as the
appropriate measure of risk. Variance, as a measure of risk, includes returns above and
below the average return, in the same vein. This has led to criticism of variance as a
measure of risk.
5. Beta computed using different market indices.
6. Up market defined as months in which market return is non-negative and other strong
criteria: (i) market return exceeds the average value of positive market returns and (ii)
market return exceeds the average value of positive market returns plus a factor (0.5
and 0.75) of the standard deviation of positive market returns.
7. The ARCH model allows the current conditional variance to be a function of the past
squared error terms. This is consistent with volatility clustering. Bollerslev (1986) later
generalised the ARCH (GARCH) model such that the current conditional variance is
allowed to be a function of the past conditional variance and past squared error terms.
The return-generating process can be written as:
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829
ARMAm. n mean: R
t
j
X
m
i1
c
i
R
ti

X
n
j1
u
j

tj

t
.
where
t
,
t1
$ 0. o
2
t

.
t1
is the information set available at time t 1, and
the conditional variance, o
2
t
is defined as:
GARCHp. q: o
2
t
c
0

X
p
i1
c
1

2
ti

X
q
j1
c
2
o
2
tj
.
8. See Gourieroux and Monfort (1992) for details.
9. Due to Bollerslev et al. (1988).
10. See also Huang (2000) for the use of a Markov regime-switching model to investigate
the instability of beta.
11. Owing to Nelson (1991).
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Corresponding author
Don U.A. Galagedera can be contacted at: tissa.galagedera@buseco.monash.edu.au
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