1640 WordsDec 23, 20147 Pages

CAPM and Factor Models
Part I: CAPM
(Mandatory for all groups)
1. Request a password for WRDS (Wharton Research Data Service) database.
2. In WRDS, find Compustat database. There you can find information on the book value of equity. Also, find information on the market value of equity and market capitalization.
3. Based on the above information, select two companies that you will work with throughout this project. The first company should be a large cap stock with high book to market (BM) ratio. The second company should be a small cap stock with low BM ratio. You can check how Prof. Kenneth French constructs these ratios. Look at the explanations from the data library on his website:*…show more content…*

3. To clarify the distinction between these concepts, let us ask: What is the difference between the SML and the CML?
Answer:
The SML describes the relationship between the systematic risk of any asset (as measured by ), and that asset’s expected return in equilibrium.
The CML describes the equilibrium relationship between the systematic risk and expected return only for efficient (i.e., extremely well diversified) portfolios.
4. What does the CAPM not provide?
It does not describe the process by which equilibrium is achieved; i.e., the process by which agents buy and sell securities, in their desire to hold efficient portfolios, thereby altering security prices and expected returns and thus requiring further changes in portfolio composition. The CAPM describes the situation after this trading process is over and investors are optimizing given the prevailing prices.
We turn now to the empirical estimation of and the problems associated therewith.
B. The Calculation of Beta: The Idea
Since the true beta is based on future anticipated returns (for which, in reality, there is no consensus forecast), how is it calculated (estimated) in practice?
1. As in all empirical work, we assume the future will be closely similar to the recent past and use past return data to compute a historical beta as our proxy for the true “future” beta.
2. Since we lack data on returns

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