A Comparison between a Dynamic and Static Approach to Asset Management Using CAPM Models on the Australian Securities Market

By Mazzola, Paul; Gerace, Dionigi | Australasian Accounting Business & Finance Journal, March 15, 2015 | Go to article overview

A Comparison between a Dynamic and Static Approach to Asset Management Using CAPM Models on the Australian Securities Market


Mazzola, Paul, Gerace, Dionigi, Australasian Accounting Business & Finance Journal


1. Introduction and Literature Review

The main objective of fund managers is to manage various assets and securities on behalf of investors and whilst doing so meet their specific investment goals. Many Fund managers attempt to construct portfolios to achieve the needs of investors by following what has now become one of the most widely used theories in modern finance, the Modern Portfolio Theory. One of the main aims of Modern Portfolio Theory is to construct an optimal portfolio by maximising returns whilst minimising risk. The objective of this study is to compare the performance of two portfolios of Australian securities: one portfolio using the Capital Asset Pricing Model (CAPM) and another using the Multiple Period Capital Asset Pricing Model (MP-CAPM). This is achieved by implementing optimal weights required for each model for the specified periods. Unlike some other research on this topic that uses simulated data, this study uses real data from securities listed on the Australian Securities Exchange to test whether the MP-CAPM is the superior model based on its ability to optimally rebalance the portfolio periodically (in this study weekly) according to changing market conditions whilst the CAPM model optimises the portfolio on day one and remains static for the selected time horizon. The obvious trade-off is between an anticipated superior return from the regularly rebalanced portfolio versus the transaction costs necessarily incurred in the rebalancing process.

Despite CAPM being widely used as an accepted pricing model, it has not prevented academics to either develop their own models that follow more realistic real world scenarios, or make extensions to the CAPM in order to avoid any unrealistic assumptions found within CAPM itself. CAPM assumes the relevant source of risk is variation associated with security returns and the risk captured by the market portfolio (Bodie et al. 2007). Moreover, it presupposes that investors base their decisions on a single-period time horizon. A model developed by Merton (1973) makes an extension to CAPM by dropping the assumption of a single-period investment horizon and the existence of the abovementioned sources of risk. Merton's model known as the Intertemporal Capital Asset Pricing Model (ICAPM) also incorporates a larger set of economic factors that can explain security returns more accurately. Amongst those characteristics examined by Merton (1973), multi-periodicity is the main focus of this study. Merton (1973) introduces us to the concept of multi-periodicity within the CAPM model, as he explains that in addition to investors facing multiple factors of risk, they also face an investment horizon with various phases related to economic cycles as opposed to the single-period horizon outlined by CAPM.

In a multiple period domain, investors are concerned with unfavourable market movements that can lead to an unwanted shift in the efficient frontier. Merton (1973) explains that investors need to be compensated for this risk of unwanted shift in the efficient frontier in addition to the market risk. The former risk can be hedged by investors if they are able to identify the variables, known as hedged factors that cause such uncertainties, (Faff and Chan 1998). Merton emphasises the significance of constructing a hypothetical hedging portfolio that will protect investors from changes in these variables. This study selects the multiple-periodicity of Merton's ICAPM whilst ignoring other factors to highlight the benefits of a dynamic model over the static model represented by CAPM where beta is calculated over a single time horizon.

Other studies have examined multiple factors in addition to multi-periodicity (Friend et al. 1976, McDonald and Solnick 1977, Faff and Chan 1998 and Bodie et al. 2007). While these studies provided extensions of the traditional CAPM model, none of them were able to isolate the effects of multi-periodicity.

This study further adopts the key assumption given by ICAPM that trading in all securities takes place continually in time. …

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