The term financial market describes any marketplace where lenders, i.e. those who have excess fund, and borrowers, i.e. those who need funds, meet together for an exchange of instruments such as equities, bonds, currencies and derivatives. The lenders in the financial market are called investors who buy financial instruments. The investors invest their fund to maximize their wealth.
In reality investors are unable to achieve their objectives at all due to poor performance of respective stock and the market conditions when they are investing in equities. The reason could be the assets may underpriced or overpriced when making investment decisions. If the investors are priced correctly for the asset by considering all relevant factors which are affecting the value, they can enjoy normal profit by appropriately pricing the asset in an efficient market. It has always been the challenge of explaining the decision process of the investors in the stock market. In this context, the behavior of investor has a close relationship with the investment decisions and the way of enriching.
The rate of return and its determinations are the major issues in Finance. The rate of return is one of fundamental criteria for allocation of resources and analysis of risk and return. Their importance can be observed in the field of corporate and personal finance when define the viability of an investment and making investment decisions. Stock returns is always be considered as the principal point when investors going to put their money in financial market.
More profit have been involved in higher risk, and vice versa. Investors should take into account their decision to invest their money in accordance with their risk-taking abilities. Many theories and models have developed to guide investors in measuring their proper risk for a given level of return, which will help investors to take a decision easier. All such theories and models unable practiced in all times in different markets. Anomalies could occur in all different conditions of the market (Ramdy 2011).
Table of Contents
CHAPTER ONE: INTRODUCTION
CHAPTER TWO: CAPM
THE MODERN PORTFOLIO THEORY
DIVERSIFICATION
SELECTION OF THE OPTIMAL PORTFOLIO
SELECTION OF THE OPTIMAL PORTFOLIO
OPTIMAL PORTFOLIO SELECTION AND THE RISK FREE ASSET
A RISK MEASURE FOR THE CML
THE CAPITAL ASSET PRICING MODEL: EXPECTED RETURN AND RISK
THE SECURITY MARKET LINE (SML)
THE MARKET BETA
CHAPTER FOUR: THREE FACTOR MODEL
CHAPTER FIVE: FOUR FACTOR MODEL
CHAPTER SIX: REWARD BETA MODEL
Research Objectives and Themes
The primary objective of this work is to explore the evolution of asset pricing models, starting from the foundations of Modern Portfolio Theory and the Capital Asset Pricing Model (CAPM), to more complex multi-factor frameworks. The research examines how investors manage the trade-off between risk and return and evaluates the empirical validity of various models in explaining stock market behavior.
- Foundations of Modern Portfolio Theory and Diversification.
- The development and limitations of the Capital Asset Pricing Model (CAPM).
- Analysis of Fama and French's Three-Factor Model.
- The incorporation of momentum factors in the Carhart Four-Factor Model.
- Introduction to the Reward Beta approach as an alternative pricing model.
Excerpt from the Book
DIVERSIFICATION
The return and risk are the important concepts in portfolio management theory and practices. The higher risk of an investment expects to have higher return. The risk of an investments is not measures what actually happening, but it measures of what is likely to be happen for investment. Markowitz, Harry (1952) Proposed that a well-diversified portfolios will gives highest level of return at given level of risk or provide minimum risk for given level of return. The individual assets combined into a set of portfolio, the expected returns of the portfolio return becomes the weighted average of the individual asset’s expected return. The weights are assigned based on the proportions of these assets held in the portfolio. However the risk of portfolio is not only depends on the weight of the respective individual asset’s risk. But also depends on the correlation between the assets includes in the portfolio (Sandberg 2005).
Markowitz (1952) provided theoretical justification for his theory of diversification which is derived from the statistical principle ‘Variance of the sample mean tends to zero when sample size tends to infinity. Though investors aware and understood this statistical norm of divarication by saying like “do not put all your eggs in one basket” (Francy 2014). Based on his principal Markowitz, Henry (1959) advocated that the investors should diversify their portfolios to being as risk adverse investor. Markowitz understood that through well Diversification and cast diversification in the framework of optimization, the risk-return trade-off of investments could be improved (Focardi & Fabozzi 2013).
Summary of Chapters
CHAPTER ONE: INTRODUCTION: This chapter introduces the fundamental concepts of financial markets, the challenges of asset pricing, and the relationship between investor behavior and decision-making.
CHAPTER TWO: CAPM: This section details the development of Modern Portfolio Theory, the importance of diversification, and the evolution of the Capital Asset Pricing Model (CAPM) for measuring risk and return.
CHAPTER FOUR: THREE FACTOR MODEL: This chapter examines the limitations of the single-factor CAPM and introduces the Fama and French Three-Factor Model, incorporating size and value premiums.
CHAPTER FIVE: FOUR FACTOR MODEL: This chapter explores the momentum anomaly and how the Carhart Four-Factor Model extends the previous framework to better capture stock return variations.
CHAPTER SIX: REWARD BETA MODEL: This chapter presents the Reward Beta approach as an alternative framework that critiques existing models and utilizes a forward-looking estimation method for cost of capital.
Keywords
Asset Pricing, Modern Portfolio Theory, CAPM, Diversification, Risk-Return Tradeoff, Systematic Risk, Unsystematic Risk, Fama-French Three-Factor Model, Momentum Anomaly, Carhart Four-Factor Model, Reward Beta, Market Beta, Portfolio Selection, Expected Return, Investment Strategy
Frequently Asked Questions
What is the core focus of this research?
The work focuses on the evolution of financial asset pricing models, tracing the development from basic portfolio theory to sophisticated multi-factor models used to determine expected stock returns.
What are the primary thematic areas covered?
The study covers modern portfolio theory, the mechanics of market risk and return, the role of firm size and book-to-market ratios, the impact of stock momentum, and alternative beta-based pricing approaches.
What is the central research question?
The research investigates how various asset pricing models explain the behavior of asset prices and whether these models can accurately determine the expected rate of return for investors.
Which scientific methods are primarily employed?
The work employs a literature-based comparative analysis of financial theories and empirical models, referencing key foundational studies in finance from the 1950s to the 2010s.
What topics are addressed in the main body of the work?
The main body treats the transition from the mean-variance analysis of Markowitz to the CAPM, the expansion into Fama and French’s Three-Factor Model, the integration of momentum factors by Carhart, and finally the Reward Beta model.
Which keywords best characterize this publication?
Key terms include Asset Pricing, CAPM, Three-Factor Model, Four-Factor Model, Reward Beta, Diversification, and Market Efficiency.
How does the Reward Beta model differ from the CAPM?
The Reward Beta model shifts from a mean-variance approach to a mean-risk assumption, incorporating forward-looking estimates rather than historical beta estimates to determine the cost of capital.
Why did researchers develop the Three-Factor Model?
The Three-Factor Model was developed because empirical studies found that the traditional CAPM could not fully explain stock returns; specifically, factors like firm size and book-to-market equity were found to have significant impacts that the single-factor CAPM ignored.
- Quote paper
- Mohamed Ismail Mohamed Riyath (Author), 2015, An Overview of Asset Pricing Models, Munich, GRIN Verlag, https://www.hausarbeiten.de/document/310573
