CAPM model and its extensions: an overview and applications
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The thesis examines the validity of the Capital Asset Pricing Model (CAPM). CAPM includes components to quantify the systematic risk of assets/portfolios and evaluate the performance of assets concerning the related market. The basis of this method is rooted in the analysis of mean-variance (return and risk), which is part of Modern Portfolio Theory (MPT). The two main components of this model are beta and Jensen’s alpha. Based on the degree of risk aversion of investors, beta helps investors construct a well-diversified or less risky portfolio, the most challenging aspect of this model. Alpha evaluates the performance of assets, even portfolio managers’ performance. We first present the concepts and mathematical foundation of CAPM and then explore the validity of the model in two different markets: the Tehran Stock Exchange (TSE), 30 selected companies, and the New York Stock Exchange (NYSE), 30 companies constituted in the Dow Jones Industrial Average (DJIA). The behavior of these markets was opposite of each other, but they both confirmed CAPM. To improve our estimation, we used the Fama-French three-factor model, which improved asset pricing in both data sets, and finally, we added the illiquidity factor to the Fama-French three-factor model, which added a bit more improvement to the Fama-French model.
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