Testing the Capital Asset Pricing Model Essay

If you see the correlation matrix for the 2 sub periods, we can see that the economic-wide risk factors have imparted positive correlations among the stock returns for Sub Period 2 (03 – 10). This was the time of economic crisis (08-10) and since most of the risk was economic, the optimal portfolio incorporates less risky assets.

4) Fama and French’s three factor model attempts to explain the variation of stock prices through a multifactor model that includes a size factor and BE/ME factor in addition to the beta risk factor. Fama-French model essentially extended the CAPM (which breaks up cause of variation of stock price into systematic risk which is non-diversifiable and idiosyncratic risk which is diversifiable) by introducing these two additional factors. Fama and French find that stocks with high beta didn’t have consistently higher returns than stocks with low beta and this indicates that beta was not a useful measure under their model. Their model is based on research findings that sensitivity of movements of the size and BE/ME factor constituted risk, and

Finance 316 practice problems for final exam 1. True or False: According to the CAPM, a stock's expected return is positively related to its beta.

Literature Review Since CAPM was accepted and admitted in fundamental concepts by most people in financial economics, factor model researching becomes a popular topic in finance. In 1992, Eugene Fama and Ken French established the empirical foundations for the Fama & French Three-Factor Model. It is designed to capture the relation between average return and size and the relation between average return and B/M (price ratios).

ADVANCED SECURITY ANALYSIS [BFF5040] “THE FAMA-FRENCH CASE STUDY” _____________________________________ GROUP ASSIGNMENT GROUP 18 ALEX LEE [26268418] JIANNAN ZHANG [25842528] XUAN ANH NGO [26274736] YIMING BAI [26413760] ZHOUJING LI [25675087] WORD COUNT: 2,918 WORDS CONTENTS EXECUTIVE SUMMARY 3 PART ONE. IN-SAMPLEAPPLICATION OF MODEL 3 1.1. FIRST-PASS REGRESSION OF 20 ASSETS 3 1.2 SECOND-PASS REGRESSION OF 20 ASSETS 4 PART TWO. OUT-OF-SAMPLE MODEL PERFORMANCE 5 2.1. CONSTRUCTION OF OUT-OF-SAMPLE PORTFOLIOS 5 2.2 EVALUATION OF OUT-OF-SAMPLE PORTFOLIOS 6 PART THREE. TESTS OF MOMENTUM-BASED PORTFOLIOS 8 3.1 CONSTRUCTION OF MOMENTUM-BASED PORTFOLIOS 8 3.2 EVALUATION OF MOMENTUM PORTFOLIOS 8 APPENDIX 12 A1 FIRST-PASS The correlation between the market portfolio and HML and the correlation between intercept and HML is -0.335 and -0.070, which indicates a moderate negative relationship between market portfolio and HML, and weak negative relationship between intercept and HML. Also, the correlations between the market portfolio and SMB, and between the SMB and HML are 0.348 and 0.191 respectively, which means that there are some positive relationships between them.

(Results are shown in Exhibit A) 3. Does momentum work? In general, we could say that the momentum does work. To justify whether it works, we first ran a regression on the Three-Factor Fama French Model (Market Excess Return, SMB and HML) from Jan 1972 to Dec 2012 respectively for the High-, 5-, Low-, and High-Minus-Low Portfolio. Then, we added momentum into the model to create a four-factor model (Momentum, Market Excess Return, SMB and HML) for the same period on a monthly basis. (See Exhibit 2).

‘The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the industry even though it is based on very strong assumptions. Discuss in the light of recent developments in the area.’

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.

Ra= Rf+ βa (Rm-Rf) To find the asset Beta (βa), we need to find the weighted average β of equity and the weighted average β of debt. We consider the β of debt to be 0, as debt has no relationship with market risk and it is evident from the balance sheet that Ameritrade had no interest bearing debt in 1997[1].

Case Problem 1: Measuring Stock Market Risk As indicated by the case study S&P 500 index was use as a measure of the total return for the stock market. Our standard deviation of the total return was used as a one measure of the risk of an individual stock. Also betas for individual stocks are determined by simple linear regression. The variables were: total return for the stock as the dependent variable and independent variable is the total return for the stock. Since the descriptive statistics were a lot, only the necessary data was selected (below table.)

The extracted data used includes monthly returns from January 1972 to July 2011. The assets are selected so that the portfolio contains the largest, most liquid, and most tradable assets. The choice of such a variety of assets across several markets was used in order to generate a large cross sectional dispersion in average return. It helped to reveal new factor exposure and define a general framework of the correlated value and momentum effects in various asset classes.

Prepared by: Lok Kin Gary Ng, contact email: gary_ng_@hotmail.com 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

a. There's a substantial unexpected increase in inflation. b. There's a major recession in the U.S. c. A major lawsuit is filed against one large publicly traded corporation. 2.  Use the CAPM to answer the following questions: a. Find the Expected Rate of Return on the Market Portfolio given that the Expected Rate of Return on Asset "i" is 12%, the Risk-Free Rate is 4%, and the Beta (b) for Asset "i" is 1.2.

Now I will discuss the results of some past paper on four factor model of CAPM. The four factor model represents an asset pricing model developed by Carhart (1997) owing to the fact that the three factor model of Fama-French (1993, 1996) could not explain the momentum effect presented by

Despite this, however, some have since suggested that their model is pure economics, and is only valid in a theoretical world that doesn’t reflect some of the frictions that actual financial markets do. Richard Roll, and University and Auburn, University of Washington, and University of Chicago educated economist, began his