Empirical Content of capital asset pricing model (CAPM) and arbitrage pricing theory (APT) across time

Soufian, Nasreen (2001) Empirical Content of capital asset pricing model (CAPM) and arbitrage pricing theory (APT) across time. In: Manchester Metropolitan University Business School Working Papers. Working Paper. Manchester Metropolitan University. ISSN 1471-857X

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Abstract

This paper examines the validity of Capital Asset Pricing Model (CAPM) and its factor models in explaining pricing of assets across time. Three sub-sets of sample are formed for different time periods on the basis that during each sub-set of samples the UK economy experienced different economic conditions (1980-1997). Consistent with Chen, Roll and Ross (1986) this paper shows that for the three subsets of time-periods, the value weighted market return, which is constructed from the sample, has significant explanatory power on pricing for all three-time periods (testing CAPM). However, its explanatory power on pricing diminishes after adding the unexpected economic factors (i.e. testing APT). This paper also identifies the underlying methodology problem of testing standard CAPM and its factor models across time: different economic factors capture the variation in average returns for different time periods. The sub-sets of samples tight up with the economic cycles, the results therefore suggest that as the riskiness of the economy changes over time, the factors at work change. In other words, the risk premia of factors change over time according to different economic conditions. These results undermine the appropriateness of the CAPM and its factor models to explain pricing of securities across time and in particular indicate that the standard methodology may be strained when applied across time.