Research on the Financial Model Selection between Capital Asset Pricing Model, Arbitrage Pricing Model, and Fama-French Model

Abstract

Financial modeling magnifies the importance of various systematic and unsystematic risks occurring in modern finance, which elicits the functionality of the Capital Asset Pricing Model (CAPM) introduced by Sharpe, Lintner, and Treynor. A considerable amount of societal support for CAPM has been triggered by its simplicity and precision in terms of making decisions for assets based on absolute risk rather than total risk. Objectively speaking, CAPM is also deeply limited by its unique prerequisites or assumptions. One pivotal point for investors to ponder is the selection of different methods and judge the individual applicability before implementation and this article aims to offer investors some financial advice derived from this process. Methods applied in this article involve information-gathering from empirical examples and tests, as well as financial analysis by comparison and selection among several models. This paper concludes that the Arbitrage Pricing Model (APM) and Fama French factor(s) Model (FFM) are differentiated and should be applied selectively and accordingly to cater to the imminent situations that investors are about to tackle.