CASE STUDY
Eugene Fama from the University of Chicago and Kenneth R. French from the Yale School of Management examined the validity of the Capital Asset Pricing Model (CAPM) in a study that was published in 1992. The CAPM is the most recognized model to explain stock price returns and forms the foundation of Modern Portfolio Theory. Their extensive study showed that, at minimum, the CAPM was not a complete explanation of the factors explaining asset pricing. Their findings also have some implications for investment performance of growth versus value stocks. A summary of their key findings can be found in Rethinking Stock Returns. After reading this summary, answer the following questions:
The CAPM is built on a single measure of risk that explains asset returns. What measures of risk did Fama and French conclude were necessary to explain stock returns?
Describe the CAPM model and the Fama and French model and the implications of these models for investors.
Discuss the limitations of the CAPM model.
Compare and contrast the CAPM model with other pricing models.
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