The Capital Asset Pricing Model

Week 1 – Introduction – Financial Accounting (Review) Week 2 – Financial Markets and Net Present Value Week 3 – Present Value Concepts Week 4 – Bond Valuation and Term Structure Theory Week 5 – Valuation of Stocks Week 6 – Risk and Return – Problem Set #1 Due Week 7* – Midterm (Tuesday*) Week 8 - Portfolio Theory Week 9 – Capital Asset Pricing Model Week 10 – Arbitrage Pricing Theory Week 11 – Operation and Efficiency of Capital Markets Week 12 – Course Review – Problem Set #2 Due

9. (10 points) You are provided with the following monthly expected returns, each of which is represented by E(Ri), and betas for the following stocks. Please estimate the capital asset pricing model and draw conclusions about the significance and realism of the results. (Note: Please use conventional tests of the R-squared and coefficients.) On the basis of your results, please name at least three of the stocks that you would recommend as “buys.”

CAPM is a model that describes the relationship between risk and expected return, and the formula itself measures the expected return of the portfolio. Mathematically, when beta is higher, meaning the portfolio has more systematic risk (in comparison to the market portfolio), the formula yields a higher expected return for the portfolio (since it is multiplied by the risk premium and is added to the risk free interest rate). This makes sense because the portfolio needs to

The CAPM is a single factor model because it based on the hypothesis that required rate of return can be predicted using one factor that being systematic risk. It looks at risk and rates of returns, compares then to the stock market providing a usable measure of risk to help investors determine what return they will get for risking their money in an investment. There are a lot of assumptions and drawbacks of CAPM that lead to the conclusion that those investors utilizing this

Financial theory accepts the belief that a share’s return should be proportional to the risk received by its holder. There is a need of a risk-return equilibrium model. Since the nativity of the efficient market hypothesis (EMH), an equilibrium model was only the Capital Asset Pricing Model (CAPM). The CAPM constitutes of two types of returns, the risk free rate of returns of the Treasury bills and beta times the return on the market portfolio. The following equation is the basis of this model:

CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.

This essay will highlight the use of Capital asset pricing model ( CAPM ) to be considered as a pricing theory model for assets . CAPM model helps investors to analyse the risk and what expectation to keep from an investment (Banz , 1981) . There are two types of risk

The capital asset pricing model can be used to determine the rate of return for an asset that is risky. This model aims at assuring that investors are compensated for the risk and the value of money. Therefore, the expected return on a security is equal to the rate of a risk-free security and the risk premium. Risk premium is the minimum amount of money expected in return of an asset that is risky. The risk premium must exceed risk-free and less risky assets.

CAPM on the other hand is based on microeconomic ideas such as concave utilities and costless diversification. Macroeconomic events mentioned include interest rates or the cost of labor, causes the systematic risk that affects the returns of all stocks. On the other hand the firm-specific events are the unexpected microeconomic events that affect the returns of specific firms for example the death of key people that would affects the firm, but would have a insignificant effect on the

In order to test the validity of the CAPM, we have applied the two-step testing procedure for asset pricing model as proposed by Fama and Macbeth (1973) in their seminal paper.

According to the CAPM model:R_i=α+βR_m+ε, α represent the abnormal return gained by the portfolio. If the market is efficiency, the α has to be zero.

Even though there are flaws in the CAPM for empirical study, the approach of the linearity of expected return and risk is readily relevant. As Fama & French (2004:20) stated “… Markowitz’s portfolio model … is nevertheless a theoretical tour de force.” It could be seen that the study of this paper may possibly justify Fama & French’s study that stated the CAPM is insufficient in interpreting the expected return with respect to risk. This is due to the failure of considering the other market factors that would affect the stock price.

One the creators was William Forsyth Sharpe born June 16, 1934 (age 81) Boston, Massachusetts, U.S is an American economist. He graduated from Riverside Polytechnic High. He is the STANCO 25, he was a professor of Finance, Emeritus at Stanford University 's Graduate school of Business, and the winner of the 1990 Nobel Memorial Prize in Economic Sciences. Sharpe was one of the originators of the capital asset pricing model. He created the Sharpe ratio for risk-adjusted investment performance analysis, and he contributed to the development of the binomial method for the valuation of options, the gradient method for asset allocation optimization, and returns based style analysis for evaluating the style and performance of investment funds.The second creator was Jack Lawrence Treynor was born on February 21 1930 and passed away in May 11, 2016. He was the President of Treynor Capital Management, Palos Verdes Estates, CA. He was a Senior Editor and Advisory Board member of the Journal of Investment Management, he was also a Senior Fellow of the Institute for Quantitative Research in Finance. He was also a editor of the CFA Institute 's Financial Analysts Journal.John Virgil Lintner, Jr. (February 9, 1916 – June 8, 1983) was a professor at the Havard Business school in the 1960s and one of the co-creators (1965a,b) of the capital asset pricing model.

Ever since Ross (1976) proposed the Arbitrage Pricing Theory (APT) as an alternative to the capital pricing model, many economists and investors have applied APT across different markets. Whereas the traditional capital pricing model explained asset returns with one beta, sensitivity to the market return, APT decomposes the return with a multiple number of factors. This idea became particularly popular for investors who aim to gain systematic risk other than market risk. However, the model specification aspect has been challenging to many practitioners as the theory does not require any specific sets of variables to be used (Azeez 2006).

Richard Roll, and University and Auburn, University of Washington, and University of Chicago educated economist, began his career researching the effect of major events of stock prices. This experience likely helped him reach the two conclusions he makes in his 1977 “A Critique Of The Asset Pricing Theory’s Tests”, one of the earliest and most influential arguments against CAPM. In the paper, Roll makes two major claims: that CAPM is actually a redundant equation that just further proves the concept of mean-variance efficiency, and that it is impossible to conclusively prove CAPM. His first claim relates to mean-variance efficiency: the idea that mathematically one must be able to create a portfolio that offers the most return for a given amount of risk. Roll claims that all CAPM is doing is testing a portfolio’s mean variance efficiency, and not actually modeling out projected future returns. The second claim in the paper is that there is not enough data about market returns for CAPM to ever prove conclusive. Even if modern technologies could help alleviate some of the burden of testing market returns for publicly traded equities, there is still no way to account for the returns of less liquid markets, where there is less public information. This means it is impossible for