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This paper examines the value of the various industries stocks using economic and financial

models. An analysis of a set of financial instruments is conducted, an analysis aimed for the

determination of the price of the financial instruments, and the determination of their true value.

The paper uses time series data on twenty stocks, from the various industries. Annually, empirical

data related to a period from January 3rd, 2000 to January 3rd, 2015 was gathered.

The CAPM model is applied to the gathered data, testing the next hypotheses, implied by the

theoretical model:

(1) There is a linear relationship between excess returns and systematic risk.

(2) Market risk as measured by is the only relevant measure of risk.

(3) Excess returns and market risk are positively related.

The results of the conducted analysis state that

Literature review

The investment decision is based on the analysis of a set of financial instruments, an analysis

through which it is aimed for a proper determination of the price of those financial instruments,

and of course, for a proper determination of their true value. Starting from Markowitzs theory,

William Sharpe (1964) showed that there is a connection between the return of an asset and the

return of a market portfolio, his model, called the Capital Asset Pricing Model, representing a

crucial step in the evaluation of primary financial instruments.

In finance, CAPM is a concept used to establish, at least at a theoretical level, the adequate rate of

return of an asset, if that asset is supposed to be added to a portfolio which has already been welldiversified, given that assets non-diversifiable risk. The formula of CAPM is:

ra = rrf + Ba (rm-rrf)

The concept takes into consideration mainly the assets response to non-diversifiable risk, which

is also known as systematic risk or market risk or beta (), as well as the market expected return

and a risk-free asset expected return.

The CAPM sustains the idea that a portfolios expected return must be equal with the risk-free

rate security plus a premium. If they are not equal, then no investment should be made in that

portfolio. The general aspect behind this model is that investors need to be compensated in from

two different point of views, time value of money and risk. The first one is represented by the

risk-free rate and it is meant to compensate the financer for putting money in an investment for a

specific period of time. The second one, the risk, is supposed to compute how much

compensation an investor should receive for taking on additional risk. This is done by taking the

risk measure, also known as beta, which compares the returns of the asset to the market for a

particular period of time and to the market premium.

The CAPM model was developed independently by William Sharpe (1963, 1964), Jack Treynor

(1961), Jan Mossin (1966) and John Lintner (1965, 1969). It represents the first model that

proves the connection between the return of an asset and the return of a portfolio which was

already diversified via a risk indicator. Out of all the authors that were mentioned above, William

Sharpe was rewarded with a Nobel Prize for his contributions in the domain of economics and

finances, along with Harry Markowitz and Merton Miller.

The CAPM model of William Sharpe (1964) and John Lintner (1965) marks the birth of asset

pricing theory. Half a century later, this model still represent the most used instrument of asset

valuation due to its simplicity and reliability, although many other tools such as Arbitrage Pricing

Theory or Mertons portfolio theory appeared.

What makes CAPM so attractive is its ability to provide powerful and intuitively pleasing

predictions regarding how to measure a risk and the relationship between expected return and

risk. Unfortunately, the empirical record of the model weak enough to invalidate the way it is

used in applications. The CAPMs essence problems may suggest theoretical flaws, as a result of

the numerous simplifying assumptions that stay behind this theoretical concept. But these flaws

can also be the result of the difficulties that occurred when implementing valid tests of the model.

For instance, the CAPM sustains the fact that the risk of a portfolio should be quantified relative

to a comprehensive market portfolio that, in principle, could contain not just traded assets, but

also consumer durables, real estate and human capital

The CAPM is built on a model of portfolio developed by Harry Markowitz (1959). In this model,

an investor is supposed to select a portfolio at time t-1 that produces return at time t. The model

assumes that investors are risk averse and, when deciding between portfolios, they only take into

account the mean and variance of their one-period investment return. Consequently, they select

mean variance-efficient portfolios, meaning that those portfolios must maximize expected

return, given a specific level of variance. Thus, Markowitzs approach is many times called a

mean-variance model.

The portfolio model provides and algebraic condition on asset weights in mean-variance

portfolios. The CAPM transforms this algebraic statement into a verifiable prediction about the

connection between risk and expected return by identifying a portfolio that must be efficient if

the asset prices are to clear the market of all assets.

Sharpe (1964) and Lintner (1965) introduce two essential assumptions to Markowitzs model to

identify a portfolio that must be mean-variance efficient. The first is called complete

agreement: given market clearing asset prices at t-1 to t, investors agree on the joint distribution

of asset returns from t-1 to t. The second assumption is that there is borrowing and lending at a

risk-free rate, which is the same for all investors and does not depend on the amount borrowed or

lent.

Based on the return required by the investors which was previously established by applying the

CAPM model, we can determine if an asset is undervalued, overvalued or correctly valued. For

example, if the estimated return of an asset is lower than the actual return, then that asset is

obviously undervalued and if the return is higher than the actual return, then the asset is clearly

overvalued. The evaluation of an asset can be done by comparing its theoretical price, which is

also supposed to be the correct one, with its market price. If the theoretical price is higher than

the market price, then we can say that the asset is worth less on the market than it should so the

asset is definitely undervalued.

The CAPM model is built on a series of hypothesis, such as:

1. Investors present a behavior such as the one described by Markowitz in his papers, so the

portfolios held by them are efficient or placed on the efficient frontier.

2. Investors build up their portfolios out of financial assets that are subject to transactions

that take place on secondary market, for example stocks or stocks, so they can borrow and

lend at a risk-free rate.

3. Investors have homogenous expectations, which is why they estimate similar distributions

for the future returns.

4. The time horizon of investments is identical for all investors.

5. Financial instruments are dividable (investors can buy/sell fractions of an asset or of a

portfolio of assets).

6. There are no transaction costs or other taxes/costs that may result from the process of

buying or selling.

7. Inflation rate is considered to be 0 and, in case it is not, it shall be considered as perfectly

anticipated.

8. Capital markets are in equilibrium, the assets being correctly evaluated.

9. There is a perfect competition between investors.

According to the CAPM concept and if the hypotheses presented above are being taken into

consideration, all investors will hold identically efficient portfolios, respectively the market

portfolio or the M portfolio. Obviously, in this case, a question regarding the reason why all

investors shall choose one market portfolio and what particular assets does this portfolio include

is understandable.

The market portfolio will include all the risky assets, as well as the stocks and bonds issued by

corporations at a national and international level and also mortgage titles, real estate, cash, art

objects etc. As a consequence, if the market portfolio includes all the risky assets, than this

portfolio is a completely diversified one from which the specific risk associated to individual

assets is put away.

In general, history acknowledges the development of the CAPM model to the works of Sharpe

(1964), Lintner (1965) and Mossin (1966). But it is Jack L. Treynor who also had a huge

contribution to the development of this concept. His revolutionary papers, Market, Value, Time,

and Risk, Treynor (1961) and Toward a Theory of Market Value of Risky Assets, Treynor

(1962), which were never published in an academic form represent the first steps of his work,

being at the same time some of the most important papers that were not published. It seems that

Treynor work took place before Sharpes, Lintners and Mossins. Anyway, while financial

analysts and economists initially credited Treynor for his development, the CAPM model

developed by him did not go too far in what concerns public reach, which is, apparently, the

reason why Treynor is not thoroughly acknowledged as one of the first contributors of the CAPM

theory.

Since the appearance of the model, there have been numerous tests undertaken to test CAPM

models validity, due to its growing popularity. While some of these were favorable for the

model, others have found evidence against him.

Tests that supported the theory

The earliest studies that have found pro arguments for the model were headed by Black, Jensen

and Scholes (1972, pg. 79-124). They used monthly returns and they have combined individual

securities portfolios in order to diversify as much of the risk specific companies and increase

accuracy estimators. The results were pro-CAPM, proving linear relationship between and

profitability indicator and the correlation between a higher/lower risk and a top / bottom return.

Another test that had supported the veracity model, had as promoters: Fama and McBeth (1973),

who also examined and showed positive and linear relationship between expected return and .

They also checked whether the residual variable or variables such factor 2 have influence on

asset portfolio returns, finding as an influential factor only .

Tests partially denied or fought against the CAPM theory

In the early 80s, some studies have suggested that there are deviations from the linear relationship

of the CAPM, because of other variables that may play a role in this. Banz(1981, pg. 3-18)

published an article that highlights the "size effect" (effect of the size of the company concerned),

which is reflected by the ability of the smaller firms shares to provide high returns to large

companies. This paradox was partially confirmed by other subsequent empirical studies, and he

clearly falls against the CAPM model: while the paradox states that in some cases the size

profitability of companies and their securities are in the inverse relationship and that therefore

this variable plays a role in explaining returns, CAPM clearly says that only affects them. Also

Reinganum revealed that firms size is important in this regard.

Keim (1983)finds a securities seasonality profitability, evidenced by a "January effect";

Litzenberger and Ramaswamy (1979,pg. 163-195), find as influential factor dividend earnings;

while Basu (1977, pg. 14-38) states as an important factor the P/E indicator.

In 1992, Fama and French (1992, pg. 427-465) used the same methodology as Fama and McBeth

in 1973, but achieved different conclusions: While the first study confirmed a positive linear

relationship between the and the expected return, the second could not do this.

And their test is criticized in turn: Black and Amihud, Christensen, Mendelson had stated that

available data were not fully relevant and Kothari, Shanken, Sloan says that Fama and Frenchs

obtained conclusions are subjective, depending very much on how they are interpreted in

statistical terms.

The model continued to be the center of debate for over 30 years and is alternatively criticized or

partially validated. Another tests are: Ning and Liu (2004, pg. 154-189) which used data from the

1996-2002 period to test the CAPM in Shanghai Stock Exchange and obtained the lack of a linear

relationship between return and that and non-systematic risk has a significant impact on return.

Cagnetti (2007, pg. 663-682) has tested the Italian capital market using a 10-years time, but he

got only a weak relationship between and profitability and the possibility that other variables to

affect the latter.

Bibliography

Amihud, Y.; Christensen, B.; Mendelson H.(1992),Further evidence on the risk relationship,

Working Paper at New York University; pg. 5-45

Banz, R.W.(1981),The relationship between return and market value of common stocks.,

Journal of Financial Economics, pg. 3-18;

Black, F; Jensen, M.C.; Scholes, M.(1972), The capital asset pricing model:some empirical

tests., Studies in the Theory of Capital Markets, pg. 79-124;

Basu, S.(1977), Investment performance of common stocks n relation to their price-earnings

ratios: a test of the efficient markets hypothesis., Journal of Finance, pg. 14-38

Cagnetti, A.(2007) , CAPM and APT n the Italian Stock Market: an empirical study.,

Unpublished article; pg. 663-682;

Fama, E.F; MacBeth, J.(1973),Risk, return and equilibrium: empirical test., Journal of

Political Economy, pg. 607-636;

Fama, E.F; French, K.(1992), The cross-section of expected stock returns., Journal of Finance,

pg. 427-465;

French, Craig W. (2003). The Treynor Capital Asset Pricing Model, Journal of Investment

Management, Vol. 1, No. 2, pp. 6072.

Keim, D.(1983),Size-related anomalies and stock-market seasonality: further empirical

evidence., Journal of Financial Economics, pg. 13-32;

Litzenberger, R; Ramaswamy, K.(1979), The effect of personal taxes and dividends and capital

asset prices: theory and empirical evidence., Journal of

Financial Economics, pg. 163-195;

Ning, G.; Liu, P.(2004), Empirical test of CAPM n Shanghai stock market., Unpublished

article; pg. 154-189;

Reinganum, M.R.(1981), The arbitrage pricing theory: some empirica results., Journal of

Finance, pg. 163-195;

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