Study on the Capital Asset Pricing Model(CAPM): literature review and possible improvements

Abstract

Capital Asset Pricing Model is one of the most classic financial models used by investors to predict the relations between risks and returns. However, with the rapid growth of global market, international corporations and fictitious assets, the whole global market becomes more complicated. For the stock markets, with more factors affecting the risks and expected returns, will these novel changes affect and make those classic financial models obsolete? This paper discusses the history of the Capital Asset Pricing Model and and studies the adaptability, assumptions, and formula of Capital Asset Pricing Model and the methods that could be used to improve this model. By carrying out data analysis, it is found out that the Capital Asset Pricing Model has shown poorer ability to predict the expected returns and risks comparing to other models that take more factors into account, such as the Fama-French Three-Factor Model. As a result, Fama-French Three-Factor Model is  analyzed in this paper to find why it provides more accurate results that fit the real situations. After that, improvements that could be added on the Capital Asset Pricing Model are proposed based on the analysis on Fama-French Three-Factor Model.