1532 Words7 Pages

Introduction
William Sharp (1964) and John Lintner (1965) develop the Capital Asset Pricing Model, which also pioneered the birth of asset pricing models. CAPM was inferred based upon the Markowitz’s (1959) theory. The theory pointed out that investors are risk averse and they are trying to find a portfolio, containing risky assets that will maximize the portfolio expected return for a given level of portfolio risk. Capital Asset Pricing Model assumes investors are risk averse and it also states how investors measure the relationship among risk and expected return. Specifically, the model suggests that there is a linear relation among risk premium and expected return, which can be depicted by beta. The basic idea behind the model is that beta*…show more content…*

CAPM was inferred based upon the Markowitz’s (1959) theory. The theory pointed out that investors are risk averse and they are trying to find a portfolio, containing risky assets that will maximize the portfolio expected return for a given level of portfolio risk. Capital Asset Pricing Model (CAPM) assumes investors are risk averse and it also states how investors measure the relationship among risk and expected return. Specifically, the model suggests that there is a linear relation among risk premium and expected return, which can be described by beta (β). The basic idea behind this model is that beta (β) is the only risk investors need to bear when holding an asset, and they call it systematic risk or market risk or undiversified risk. In 1993, based on CAPM, Fama and French develop a three-factor model, containing two more factors, i.e. book-to-market and size factor. The comprehensive three factors are market factor, which mainly illustrated by CAPM, book-to-market ratio and market capitalization. Fama and French successfully point out that book-to-market ratio and market capitalization are the two factors that can affect stock returns and could be used to explain the asset return deviation, which cannot be captured by CAPM. There is also a linear relationship among the expected return of the asset and the three factors. Thereafter, Carhart (1997) adds momentum to Fama and French three-factor model, which signals the birth of Carhart Four-Factor model. The forth factor is considered to be related to investor behaviour. Investors will buy those assets that perform quite well and sell those that perform badly in the past. Investors may make excess profits based on the past performance of the assets. This profit is called momentum profit. The trading philosophy behind the model is that it may have some correlation between

CAPM was inferred based upon the Markowitz’s (1959) theory. The theory pointed out that investors are risk averse and they are trying to find a portfolio, containing risky assets that will maximize the portfolio expected return for a given level of portfolio risk. Capital Asset Pricing Model (CAPM) assumes investors are risk averse and it also states how investors measure the relationship among risk and expected return. Specifically, the model suggests that there is a linear relation among risk premium and expected return, which can be described by beta (β). The basic idea behind this model is that beta (β) is the only risk investors need to bear when holding an asset, and they call it systematic risk or market risk or undiversified risk. In 1993, based on CAPM, Fama and French develop a three-factor model, containing two more factors, i.e. book-to-market and size factor. The comprehensive three factors are market factor, which mainly illustrated by CAPM, book-to-market ratio and market capitalization. Fama and French successfully point out that book-to-market ratio and market capitalization are the two factors that can affect stock returns and could be used to explain the asset return deviation, which cannot be captured by CAPM. There is also a linear relationship among the expected return of the asset and the three factors. Thereafter, Carhart (1997) adds momentum to Fama and French three-factor model, which signals the birth of Carhart Four-Factor model. The forth factor is considered to be related to investor behaviour. Investors will buy those assets that perform quite well and sell those that perform badly in the past. Investors may make excess profits based on the past performance of the assets. This profit is called momentum profit. The trading philosophy behind the model is that it may have some correlation between

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