An empirical evaluation of capital asset pricing models on the JSE
Date
2014-03-07
Authors
Sacco, Gianluca Michelangelo
Journal Title
Journal ISSN
Volume Title
Publisher
Abstract
The Capital Asset Pricing Model (CAPM), as introduced by Markowitz (1952), Sharpe (1964), Lintner
(1965), Black (1972) and Mossin (1966), offers powerful and intuitively pleasing predictions about
the risk and return relationship that is expected when investing in equities. Studies on the empirical
strength of the CAPM such as Fama and French (1992), however, indicate that the model does not
reflect the share return actually obtained on the equity market. Attempting to improve the model,
Fama and French (1993) enhanced the original CAPM by incorporating other factors which may be
relevant in predicting the return on share investments, specifically, the book – to – market ratio and
the market capitalisation of the entity. Carhart (1997) further attempted to improve the CAPM by
incorporating momentum analysis together with the 3 factors identified by Fama and French (1993).
This research report empirically evaluates the accuracy of the above three models in calculating the
cost of equity on the Johannesburg Stock Exchange over the period 2002 to 2012. Portfolios of
shares were constructed based on the three models for the purposes of this evaluation.
The results indicate that the book-to-market ratio and market capitalisation are able to add some
robustness to the CAPM, but that the results of formulating book – to – market and market
capitalization portfolios is highly volatile and therefore may lead to inconsistent results going
forward. By incorporating the short run momentum effect, the robustness of the CAPM is improved
substantially, as the Carhart model comes closest to reflecting what, for the purposes of this study,
represents the ideal performance of an effective asset pricing model. The Fama and French (1993)
and Carhart (1997) models therefore present a step forward in formulating an asset pricing model
that will hold up under empirical evaluation, where the expected cost of equity is representative of
the total return that can be expected from investing in a portfolio of shares. It is however
established that the additional factors indicated above are volatile, and this volatility may influence
the results of a longer term study.
Description
Keywords
Capital assets pricing model, Johannesburg Stock Exchange, Stocks, Prices