Capital Asset Pricing Model (CAPM) and Efficient Market Hypothesis (EMH) Contributing to the Global Financial Crisis (GFC)

The Efficient Market Hypothesis (EMH) and Capital Asset Pricing Model (CAPM) are a framework and standard financial tool, respectively. Together, they provide a worldview for financiers and determine their decision-making in the financial markets.

Fama (1965; 1970) introduces the EMH in three market efficiency levels: a strong level where all relevant information regarding a stock is fully reflected in its price; a semi-strong level where all publicly available information is reflected in its price; and a weak level where current prices reflex all past history of the prices.

Fama and French (2004, p. 25) note that CAPM of William Sharpe (1964) and John Lintner (1965) marks the birth of asset pricing theory (resulting in a Nobel Prize for Sharpe in 1990). Four decades later, the CAPM is still widely used in applications, such as estimating the cost of capital for firms and evaluating the performance of managed portfolios. It is the centerpiece of MBA investment courses. Indeed, it is often the only asset pricing model taught in these courses.

However, Fama and French (2004) evaluate the performance of CAPM and conclude that empirical evidence invalidates the use of CAPM in applications, after finding that passive funds invested in low beta, small or value stocks tend to produce positive abnormal returns relative to CAPM predictions. This is relevant to EMH for two reasons; the criticisms come from the founder of EMH, Fama, and CAPM builds on the assumptions of EMH. Put simply, those using the CAPM invest more heavily in higher risk investments than is optimal, which contributes to the Global Financial Crisis (GFC). If these models continue to be taught in financial courses, they will help set the stage for the next GFC.

The ideas discussed in this article are taken from and elaborated in Adaptive Interactive Expectations.

References

Fama, EF 1965, ‘The Behavior of Stock-Market Prices’, Journal of Business, vol. 38, no. 1, pp. 34-105.

— 1970, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’, Journal of Finance, vol. 25, no. 2, pp. 383-417.

— 1998, ‘Market efficiency, long-term returns, and behavioral finance’, Journal of Financial Economics, vol. 49, no. 3, pp. 283-306.

Fama, EF & French, KR 2004, ‘The Capital Asset Pricing Model: Theory and Evidence’, Journal of Economic Perspectives, vol. 18, no. 3, pp. 25-46.

Lintner, John. 1965. “The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets.” Review of Economics and Statistics. vol. 47, no. 1, pp. 13-37.

Sharpe, William F. 1964. “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” Journal of Finance. vol. 19, no. 3, pp. 425- 42.

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