Why CAPM fails to tell the whole story! An investment strategy based on the equity premium puzzle

Lasse Pedersen

Student thesis: Diploma thesis

Abstract

While Capital Asset Pricing Model have been around since the mid 60'ies no other model in the world of finance have a more fundamental role as CAPM do in portfolio analysis. This is true even though CAPM, fails to tell the whole story regarding the market. This dissertation looks at why CAPM fails to tell the whole story. Most written journals and publicly displayed research chooses to focus on the American stock market. This is due to the waste amount of data available in corresponding with the American stock market being the largest in the world. This dissertation on the other hand looks at the models made for the American market and then project it onto the Danish stock market. The dissertation takes the CAPM model and proves that as a statistic model CAPM is not a significantly correct one to use. The results are quite clear that CAPM in recent years have an ability to interpret the market changes with almost zero percent correctness. I order to show why CAPM might be failing, this dissertation looks at 3 alternative premiums in the market. The specific premiums are as follows: Smallcap premium Value premium Sector premium It finds that all these premiums appear to be present in the danish stock market but due to lacking data, it has not been possible to scientifically prove their existence. From these three premiums only 2 of the was interesting enough to put to the test, as a investment strategy. Here it was concluded that only the sector premium could produce super high returns in the stock market. It could even produce returns that beat the markedet by many factors over the course of 15 years investment period.The result in this dissertation is the definitive conclusion that CAPM as a model is not correct. And then it chooses some premiums which then can be discussed. But because of lacking data they can not be proven, but serve as a possible appetite for further research, perhaps in the American stock market which have shown to have more data availible.

EducationsGraduate Diploma in Finance, (Diploma Programme) Final Thesis
LanguageDanish
Publication date2013
Number of pages77