Limitations of CAPM and Empirical Analysis based on the Fama-French Three-Factor Model

Xinxuan Wu ()
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Xinxuan Wu: Rotman Commerce, University of Toronto, Finance and Economics

A chapter in Proceedings of the 2026 11th International Conference on Financial Innovation and Economic Development (ICFIED 2026), 2026, pp 136-144 from Springer

Abstract: Abstract This paper critically evaluates the inherent limitations of the Capital Asset Pricing Model (CAPM) and explores the improvements introduced by the Fama-French three-factor model. As a pioneering achievement in asset pricing theory, CAPM established a linear relationship between systematic risk and expected return. However, its explanatory power is constrained by several restrictive assumptions, including perfectly efficient markets, rational and risk-averse investors, and homogeneous expectations. Furthermore, the model relies solely on a single market beta coefficient. It overlooks the impact of other dimensions of systemic risk and thereby limits its empirical validity. An applied case study of Apple Inc. demonstrates that CAPM fails to capture firm-specific performance drivers such as technological innovation and investor sentiment, resulting in significant deviations between predicted and actual returns. The Fama-French model partially addresses these shortcomings by incorporating size (SMB) and value (HML) factors, providing an improved framework for explaining cross-sectional return differences. Nevertheless, this model retains flaws: its factors exhibit unstable correlations across markets and time periods, and it overlooks anomalies like momentum, profitability, and investment activity. These findings underscore that asset pricing models should be viewed as dynamically evolving tools rather than fixed formulas. Despite the significance of the three-factor model, it ultimately fails to resolve the complexity inherent in estimating expected returns.

Keywords: Fama-French Three-Factor Model; Capital Asset Pricing Model (CAPM); Size Effect (SMB) (search for similar items in EconPapers)
Date: 2026
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DOI: 10.2991/978-94-6239-642-5_15

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