CAPM

1
CAPM

• Sharpe (1964) at Stanford University
• www.wsharpe.com
• Basis for cost of capital,
• portfolio evaluation
• E(R) Rf B (ERm Rf) Rf (ERm Rf) B
• Market is the only factor
• Linear relationship between return and beta risk.

2
TEST of the CAPM model

• We know CAPM looks like
• E(Ri) Rf bE(MKT)
• OR E(Ri) - Rf bE(MKT) (A)
• where MKT market return - risk free return
• Now consider a regression model
• Ri - Rf a b MKT e
• Taking expectation on both sides,
• E(Ri) - Rf a bE(MKT) since E(e) 0. (B)

3
TEST of CAPM model

• E(Ri) - Rf bE(MKT) (A)
• E(Ri) - Rf a bE(MKT) (B)
• By comapring (A) and (B), the equations become
  identical when a 0.

4
Testable Implications of CAPM

• Therefore,
• 1. The CAPM model implies that the intercept in
  the regression (a) is equal to zero. Ho a 0
• 2. Another implication is that Market (MKT) is
  the only factor determining expected return.

5
DATA

• MKT market - risk-Free
• R3000 - TBill
• Where R3000 is a broad-based market index by
  Russell (Refer to the class website under Other
  Useful Link for Russell Co.)
• Tbill is 3-month treasury bill from Federal
  reserve (refer to the class website)
• Go to FFnote file on the website for the data
  and regression (in Chapter 7,8,9,10)

6
Fama and French's 3 Factor Asset Pricing Model

• E(Ri) Rf bE(MKT) cE(SMB) dE(HML)
• MKT MARKET - RISK-Free R3000 TBill
• SMB SMALL - BIG R2000 R1000
• HML High BK/MKT - Low B/M
• (R1000V R2000V)/2 - (R1000G R2000G)/2
• All indexes are from russell.com

7
Fama and French's 3 Factor Asset Pricing Model

• FF model
• Ri Rf B1(MKT) B2SMB B3HML
• (Read Faff paper on the class website)
• Regression
• Ri - Rf a B1(MKT) B2SMB
  B3HML
• Testable implication
• Ho a 0.

8
TEST OF FF model

• Regress the excess return of a set of
  portfolios (Ri - Rf) against the excess market
  return, SMB and HML
• and see whether the average of the intercept
  estimates is close to zero.
• Go to FF_Note for the regression results.
• For Tomorrow, Read Chapters 9 and 10