Day 82 in MIT Sloan Fellows Class 2023, Managerial Finance 8, CAPM
CAPM(Capital Asset Pricing Model)
Assumptions
- Efficient portfolios are combinations of market portfolio and risk-free rates(Treasury bills)
- The expected return of an asset i must satisfy
- There is a linear tradeoff between risk and expected return: that's CAPM
Rm assumes the largest portfolio you can assume, however practically everyone tends to use the market index.
Practical data collection
Based on the timeframe and methodology to collect the data, you can estimate minus beta as well.
Two strong assumptions in "CAPM"
Total risk = Systematic risk(beta^2 * VAR(Rm, t+1)) + Idiosyncratic risk(VAR(ei, t+1))
The regression implies E(Ri) - Rf = alpha + beta(E(Rm) - Rf)
Then, CAPM implies alpha equals zero.
CAPM always assumes alpha equals zero because alpha means there is an incremental benefit that does not correlate with the market return.
Buffetts Alpha
http://docs.lhpedersen.com/BuffettsAlpha.pdf
For instance, Warren Buffett’s Berkshire Hathaway has realized a Sharpe ratio of 0.79 with significant alpha to traditional risk factors. The alpha became insignificant, however, when we controlled for exposure to the factors “betting against beta” and “quality minus junk.”
The limitations of CAPM
Fama and French portfolios clarified two exceptions in CAPM.
- Size matters: Small stocks outperformed large stocks
- market premium matters: Stocks with high ratios of book-to-market value outperformed stocks with low ratios
