The Effectiveness of Asset Pricing Models Under Special Conditions: Evidence from the COVID-19 Pandemic, Emerging Markets, and Financial Crises

Abstract

Asset pricing models are important tools in finance. However, special market conditions can make them highly ineffective. This paper evaluates the performance of classical asset pricing models (that is, CAPM and Fama-French models) under three specific scenarios: the COVID-19 pandemic, emerging markets, and financial crises. Recent research and market data are reviewed to conclude that these models have very low efficiency in times of extreme occurrences for capturing proper asset valuations. Our findings reveal that standard models lose a substantial part of their explanatory power in periods of crises while new context-specific risk factors come into existence in other exceptional conditions. This work argues for the inclusion of liquidity and tail risk considerations, especially during market stress, as we also observe a greater need for more dynamic and adaptive modeling approaches that capture time-varying risk premia and factor loadings. The findings drive home the point that standard asset pricing models cannot be applied across the board in all market conditions and stress the need for developing more flexible and situation-specific valuation tools. Therefore, this research lies in its dual contribution, both in academic terms and practical finance, by providing an understanding of the behavior of asset pricing models in extreme markets and giving indications for future model development.