TO WHAT EXTENT CAN SINGLE AND MULTI-FACTOR ASSET PRICING MODELS

FORECAST FUTURE
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[Replace the following names and titles with those of the actual contributors: Dorena Paschke, PhD1; David Alexander, PhD2; Jeff Hay, RN, BSN, MHA3, and Pilar Pinilla, MD4
1[Add affiliation for first contributor], 2[Add affiliation for second contributor], 3[Add affiliation for third contributor], 4[Add affiliation for fourth contributor]
Kristof Madani, k.s.madani@stu.mmu.ac.uk

1) ABSTRACT 4) METHODS

Asset pricing models are important tools to understand pricing mechanisms in the The methodology of the research follows the work of Fama and MacBeth (1973) and Interestingly, during 2015, when CAPM Expected vs Realized Returns
financial markets. These models not only help to evaluate portfolio returns, but can also Pettengill et al. (2013). The betas of securities are estimated at the end of the 36-month- 2015
the FTSE 100 has lost from its 0.08
be used to predict future expected returns. Because they are a key tool in asset long sample periods from 2010 onwards, to get them for 2013, 2014 and 2015. For these value, Portfolio 5 completely 0.06
management, understanding the effectiveness of such models is crucial. Such easy-to- years, the predicted expected returns of portfolios are compared to realised returns.
outperformed expectations. 0.04
understand models can be used by people who do not have experience in investing but Securities from the London Stock Exchange’s FTSE 100 are analysed and sorted into 0.02
want to evaluate different investments easily based on numbers. portfolios, based on their betas. 0
1 2 3 4 5
-0.02

-0.04
The aim of this research is to compare one of the most influential asset pricing models, -0.06
i.e. the Capital Asset Pricing Model, which states that only the sensitivity to market risk -0.08
affects returns, to the Fama and French Three-Factor Model, which brings in individual -0.1

firm characteristics into the equation. By using these two models returns after the recent Exp Real

financial crisis will be predicted. Based on previous 36 months, yearly predictions from
2013 to 2015 will be made and compared to realised returns in order to evaluate the
predictive power of the models. The results are compared to previous empirical studies,
to see whether there has been a shift in predictive power due to the 2007-2009 financial
crisis.

2) BACKGROUND 5) RESULTS OF CAPM 6) CONCLUSIONS

Single factor or multi-factor asset pricing models The sample period shows that low risk investors are benefiting from higher returns than
are used in order to determine the value of assets.
For all three years, the expected CAPM Expected vs Realized Returns
2013 expected.
There is a close relationship between expected return on portfolios were in line
0.35
return and risk, which can be formalised by using with the CAPM theory: the 0.3
asset pricing models. highest beta portfolio had the In other empirical studies the CAPM method showed similar aspects, and the Fama and
0.25
French Three-Factor Model had similar out of sample predicting power as the CAPM.
highest expected return, while 0.2
Capital Asset Pricing Model (CAPM) was the lowest had the lowest. 0.15
developed by Sharpe (1964), Lintner (1965) and Overall, from an investor’s point of view, risk-neutral investors are in the worst position
Mossin (1966). It was developed after Markowitz 0.1
(Portfolio 2, 3 and 4) and risk averse-and risk-seeking (Portfolio 5 and 1) are experiencing
(1952) defined that only systematic risk has to be 0.05
the best results compared to their risk profiles.
assessed because the risk of individual 0
1 2 3 4 5
components within a portfolio can be eliminated
by diversification. The CAPM is based on this idea Expected Return Realized Return
Although the CAPM (as well as the FF3 Model) does not predict the expected returns well,
that the expected excess return on a portfolio is it can still provide a guideline in terms of investing in different assets with different risk
given by only one factor: the sensitivity to the
profiles.
market portfolio.

Fama and French (1992, 1993) has built their However realized returns are far
model on the empirical findings of the CAPM and CAPM Expected vs Realized Returns
from expected returns, moreover 2014
other models, and concluded that apart from the
security’s sensitivity to market returns, the book-
lower risk portfolios had higher 0.14

to-market (BtM) ratio and the firm size have to be returns than high risk portfolios, 0.12

included in the model. which is not in line with the 0.1

theory. 0.08

0.06
3) OBJECTIVES 0.04
7) REFERENCES
Portfolio 5 outperforms 4 and 3 0.02

• To review the theoretical framework of different asset pricing models; during the three year sample 0 • Fama, E. & French, K. (1992). The cross-section of expected stock returns. Journal of Finance, 47, 427-465.
period, even though it should 1 2 3 4 5
• Fama, E. & French, K. (1993). Common risk factors in the returns on stocks and bonds. Journal of Financial
Exp Real
have provided with the lowest • Sharpe, W. (1964). Capital asset prices: A theory of market equilibrium under conditions of risk. Journal of
• To empirically analyse and measure the predictive power of the models after the 2007- Finance, 19, 425-442.
2009 financial crisis; returns.
• Lintner, J. (1965). The valuation of risk assets and the selection of risky investments in stock portfolios and capital
budgets. Review of Economics and Statistics, 47(13-37).
• Mossin, J. (1966). Equilibrium in a capital asset market. Econometrica, 34, 768-783.
• To compare the results to other empirical analyses that were conducted before the
• Markowitz H. (1952). Portfolio selection. Journal of Finance, 7, 77-91.
financial crisis.