Discuss the Evidence of the Tests Carried out to See If the Cap-M Does Describe the Real World.

Since this model was presented analysts and researchers have carried out ongoing observations and experiments to test the theory behind the capital asset pricing model. Some of the tests are carried out to prove the model more accurately and improve it and some are to question it. Capital asset pricing model was developed to simplify Markowitz theory using real world assumptions. It states that high beta stock should have a higher expected return. This goes onto saying that in equilibrium an asset with zero systematic risk, where (β=0), will have expected return equal to that on the risk less asset. Also expected return on all risky securities, where (β>0), will be higher by a risk premium which is directly proportional to their risk as measured by β.

Tests that were carried out in the beginning involved estimating betas using time series regression and then running a cross section of regression using the estimated betas to test the hypotheses of the model. The first test that used this method of testing was carried out by Lintner (1965) and Douglas (1968). The results showed that they contradicted with the capital asset pricing model, but both of their studies did have statistical weaknesses which might explain the results. The error was that they estimated individual stock betas whilst the fact is that estimated betas and risk are correlated.

Another test that was carried out was in 1973 by Fama and Macbeth. Their test involved ‘combining the time series and cross sectional steps to investigate whether the risk premium of the factors in the second pass regression is non-zero.’ They grouped shares in twenty portfolios and estimated past betas using the methodology explained above. They then carried out a cross sectional regression for each month from 1935-1968. The results showed that the coefficient of beta was insignificant because its value was too small. They also found out that the residual risk has no affect on the return of the securities and the risk premium is much smaller than the capital asset pricing model.

As many tests have proved that the capital pricing asset model is not as accurate as first thought and limits it practical use, other models have had to be introduced to help investors with their decisions. The model that was designed in 1976 by Stephen Ross