ASSET PRICING MODELS: CAPM VS FAMA-FRENCH MULTIFACTOR MODEL

Abstract

The Capital Asset Pricing Model (CAPM) and the Fama-French Three-Factor Model are two cornerstone asset pricing models used to assess the risk-return trade-off in financial markets. While CAPM focuses on a single factor—the market risk premium—Fama and French introduced additional factors (size and value) to better explain asset returns. This paper compares the predictive power, applicability, and limitations of the CAPM and Fama-French models within the context of Pakistan’s stock market. Using data from the Pakistan Stock Exchange (PSX) from 2010 to 2024, the study evaluates the two models' ability to explain stock returns and assesses their performance using various statistical measures such as R-squared, Sharpe ratios, and alphas. The results indicate that the Fama-French model outperforms CAPM in explaining stock returns, particularly for small-cap and value stocks. However, both models have limitations due to the unique characteristics of the Pakistani market.