Capital Asset Pricing Model (CAPM

)

A Case from China¶s Stock Market

The methodology used to test the CAPM .CAPM: A great innovation in the field of finance invented by William Sharpe (1963 1964) and John Lintner (1965 1969) Objectives: 1.The expression and meaning of the CAPM 2.

1. The Expression and Implication of the CAPM The CAPM quantifies tradeoff between risk and expected return and yields the following expression: E(Ri) = Rf + [E(Rm) ± Rf]FI F i ! cov.

Rm / H (2Rm ) .Ri .

The Expression and Implication of CAPM   The essence of CAPM is that the expected return on any asset is a positive linear function of its beta and that beta is the only measure of risk needed to explain the cross-section of expected returns. . The spirit of CAPM is F .1. no CAPM. No F .

2. Methodology: Fama-MacBeth Approach The basic idea of the approach is the use of a time series (first pass) regression to estimate betas and the use of a cross±sectional (second pass) regression to test the hypothesis derived from the CAPM. .

we first run the following regression over time to estimate beta: Rit ! E i  F i Rmt  Li (1)  Step 2 (Second-Pass Regression) We run the following cross-section regression over the sample period over the N securities: R it ! KÖ 0 t  KÖ1 t F i  KÖ 2 t F i2  KÖ 3 t S ei  L it (2) . Methodology: Fama-MacBeth Approach  Step 1 (First-Pass Regression): For each of the N securities included in the sample.2.

Methodology: Fama-MacBeth Approach    1). KÖ3 should not be significantly different from zero. 2). namely. KÖ2 should not be significantly different from zero. 3). or the expected return on any asset is a positive linear function of its beta.2. a positive relationship exists between systematic risk and expected return. KÖ1 must be more than zero: there is a positive price of risk in the capital markets. . or residual risk does not affect return.

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