Capital asset pricing model (CAPM) and Fama-French three factor model (FF3)
The Capital Asset Pricing Model (CAPM) is a financial model that interprets the any possible relationship between the systematic risk of an individual stock or portfolio and its expected return. The model first introduced by William Forsyth Sharpe in 1964 as an extension of the earlier research done by Harry Markowitz about modern portfolio theory. CAPM theory considers the Beta as the only important factor that affects the expected return of an asset. Despite being simple to use and depict, the model is disapproved by many scientists because of its unrealistic assumptions and lack of ability to explain the risk-return connection. However later in 1993 Eugene Fama and Kenneth French came up with the adjusted version of model (FF3) which has 2 more factors that would affect the required return of an investment. In this paper we will test both of those models on 30 individual stocks on monthly returns in New York Stock Exchange (NYSE) to see how strong is the beta and 2 other factors are in terms ofexplaining the average returns.
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