Econometric Analysis of Capm

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Prepared by: Lok Kin Gary Ng, contact email: May, 2009 School of Economic Introduction The analysis of this paper will derive the validity of the Fama and French (FF) model and the efficiency of the Capital Asset Pricing Model (CAPM). The comparison of the Fama and French Model and CAPM (Sharpe, 1964 & Lintner, 1965) uses real time data of stock market to practise its efficacy. The implication of the function in realistic conditions would justify the utility of the CAPM theory. The theory suggests that the expected return demanded by investors on a risky asset depends on the risk-free rate of interest, the expected return on the market portfolio, the variance of the return on the market portfolio, and…show more content…
Hence, Fama & French’s three factor model flourished when considering the market book value and the size of business. Additionally, in Fama and French’s (1996) paper, they concluded Sharpe – Lintner’s CAPM has never been an empirical success. According to the current study, the factors that affected the Beta are serious enough to invalidate most applications of the CAPM 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. Specification of model The primary estimated model is presented as; rprft = α0 + β1(rmrf)t + β2(smb)t + β3(hml)t + εt This FF three factor model is derived from the CAPM (Peirson et al, 2007); E(Rp)t – Rft = (1(E(Rm) –Rf)t Given that; (i = Cov(Rp,Rm) = risk factor on the portfolio with respect to the market. ((m)2 This leads to the secondary estimated model, this can be rewritten as; rprft = (0t +(1(rmrft) + εt Under both of these models; • Assume a common pure rate of interest, with all
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