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CAPM

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Testable Implications of CAPM. Therefore, ... 2. Another implication is that Market (MKT) is the only factor determining expected return. ... – PowerPoint PPT presentation

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Title: 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
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