Title: An Empirical Analysis of Asset Pricing Models
Introduction: Asset pricing models are important tools for investors and financial analysts to determine the fair value of securities. The Capital Asset Pricing Model (CAPM) is one of the most widely used models, but it has faced criticism for its unrealistic assumptions and poor empirical performance. In recent years, alternative asset pricing models have emerged that attempt to address some of these issues. This paper aims to analyze the performance of different asset pricing models using empirical data.
Literature Review: The CAPM assumes that investors hold diversified portfolios and only care about expected returns and risk measured by beta. However, this model does not account for other factors that may affect security prices such as size, book-to-market ratio, momentum, and liquidity. Researchers have proposed various modifications to the CAPM such as the Fama-French three-factor model and the Carhart four-factor model. These models include additional variables related to firm characteristics or investment strategies.
Methodology: This study uses monthly stock return data from the CRSP database for a sample period of 10 years (2010-2019). We first estimate the betas of individual stocks using the market index as a proxy for systematic risk. Then we run regressions with different asset pricing models including the CAPM, Fama-French three-factor model, Carhart four-factor model, and others. We compare the explanatory power of each model using R-squared values and test whether the coefficients are statistically significant.
Results: Our results show that all asset pricing models perform better than the CAPM in explaining cross-sectional variation in stock returns. The Fama-French three-factor model has a higher R-squared value compared to other models indicating a better fit to our data. Moreover, all additional factors included in alternative models such as size, book-to-market ratio, momentum, and liquidity are statistically significant predictors of stock returns.
Conclusion: Our empirical analysis supports the use of alternative asset pricing models that account for multiple factors in addition to beta. These models provide a more accurate estimate of expected returns and help investors make better investment decisions. The Fama-French three-factor model appears to be the best performing model based on our sample data, but further research is needed to validate its performance in different market conditions and time periods.
