3/13/2023 0 Comments Capm model with alpha pdf![]() ![]() Here is a recap of exactly how the Fama French factors are created, a video on how the Fama French model works (see below), and a spreadsheet.Īccording to the CAPM, the EW CRSP index has an alpha of roughly 2.5%/year. In words, the Fama French model claims that all market returns can roughly be explained by three factors: 1) exposure to the broad market (mkt-rf), 2) exposure to value stocks (HML), and 3) exposure to small stocks (SMB). I also recommend reading the CAPM chapter from Ivo Welch’s finance book to “freshen up” on your quantitative factor model knowledge (admit it, upon graduation from your MBA program you threw all that knowledge out the window!) The Fama and French 3-factor Modelįirst, here are the links to the 3-factor model source documents if you enjoy reading archaic academic finance journals: Fama French 1992 and Fama French 1993. We have our own factor data library that you may access as well. Ken French houses one of the richest data resources on the web–I like to call it “MSCI Barra for broke people.” Here’s the link to his factor research. The 3-factor model is great, but how the heck does one estimate the FF factors?ĭartmouth Professor Ken French comes in for the rescue! For example, according to Fama French 1993, the 3-factor model explains over 90% of the variability in returns, whereas the CAPM can only explain ~70%! And while the FF model inputs are highly controversial, one thing is clear: the FF 3-factor model does a great job explaining the variability of returns. Given the CAPM doesn’t work that well in practice, perhaps we should look into how to use the Fama French model (which isn’t perfect or cutting edge, but a solid workhorse nonetheless). Regardless, being that this blog is dedicated to empirical data and evidence, and not about ‘mentally masturbating about theoretical finance models,’ we’ll operate under the assumption that the CAPM is dead until new data comes available. Roll’s critique–maybe the CAPM isn’t a junk theory, rather, the empirical tests showing the CAPM doesn’t work are bogus.Everyone learns about it and knows how to use it (although, Graham and Harvey suggest that many practitioners don’t even apply the CAPM theory correctly).Of course, there are lots of arguments to consider before throwing out the CAPM. It is also interesting that CFOs pay very little attentionto risk factors based on momentum and book-to-market-value.” ”…practitioners might not apply the CAPM or NPV rule correctly. Of course, even if it is applied properly, it is not clear that the CAPM is a very good model. ![]() “While the CAPM is popular, we show later that it is not clear that the model is applied properly in practice. Welch (2008) finds that ~75% of professors recommend the use of the model when estimating the cost of capital, and Graham and Harvey (2001) find that ~74% of CFOs use the CAPM in their work.Ī few quotes from Graham and Harvey 2001 sum up common sentiment regarding the CAPM: Given such a poor track record, is anyone still using the CAPM? If you’d like to see how I calculated the charts above, please reference the excel file. Moreover, closer inspection indicates that the small-value and the small-growth portfolios are really out of wack. Additional information regarding the construction of these results is available upon request.Īgain, the CAPM doesn’t do a good job of explaining returns. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. ![]()
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