Investing on the CAPM Pricing Error

José Carlos De Souza Santos,Elias Cavalcante Filho

doi:10.4236/ti.2017.81006

Abstract

We tested an investment strategy based on the pricing error of the CAPM model. Starting with the Markowitz (1952) [1] methodology, we replaced the standard expected returns vector with the expected errors vector from the CAPM model, assuming that such errors are nonzero and persist over time. When evaluated over the entire examined period, all of the resulting portfolios outperformed the market portfolio. Except for some shorter periods, our hypothesis was fully confirmed. That is, the performance of our alpha portfolios was significantly better than the market portfolio. In other words, the pricing error of the CAPM model seems to be nonzero and to have an inertial component.

Highlights

The goal of this study is to determine whether the pricing error of the capital asset pricing model (CAPM) model by William Sharpe (1964) [2] and Lintner (1965) [3] exhibits an inertial component
The CAPM model states that the expected return of a given asset satisfies the following formula: ( ) ( ) E Ri − Rf =αi + βi E Rm − Rf where Ri is the return on asset i ; Rf is the risk-free return; Rm is the market return; and αi is the expected pricing error of asset i
We evaluated an investment strategy by betting on pricing errors made by the CAPM model, under the hypothesis that these errors are non-zero and persist over time

Summary

Introduction

The goal of this study is to determine whether the pricing error of the CAPM model by William Sharpe (1964) [2] and Lintner (1965) [3] exhibits an inertial component. Fama and French (2004) [4] state that CAPM is still widely used for pricing in both academia and industry. The CAPM model states that the expected return of a given asset satisfies the following formula:. ( ) ( ) E Ri − Rf =αi + βi E Rm − Rf where Ri is the return on asset i ; Rf is the risk-free return; Rm is the market return; and αi is the expected pricing error of asset i. That the model assumes that the pricing error is zero, that is, that αi= 0, ∀i ∈{1, 2, , N} , where N is the number of available assets.

Objectives

Methods

Results

Conclusion