Capital Asset Pricing Model

“Analysis and application to IBM”

Ramberto Jr. Sosa Cueto

Submitted in Partial Fulfilment

Of the Course Requirements

For Risk Management

FIN 619

Master of Arts in Applied Economics

Spring 2016

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 Table of Contents
Introduction .......................................................................................................................... 2
Capital Asset Pricing Theoretical Development ...................................................................... 3
Mathematical Model ............................................................................................................. 4
Model Equilibrium ................................................................................................................. 5
Assumptions ......................................................................................................................... 6
Implications .......................................................................................................................... 7
Econometric Model ............................................................................................................... 8
Estimation method and Data ................................................................................................. 9
Results and hypothesis test ................................................................................................. 10
Investment decisions ........................................................................................................... 13
Portfolio Investment Decisions ............................................................................................ 14
Conclusion........................................................................................................................... 16
Bibliography ........................................................................................................................ 18
Appendix I ........................................................................................................................... 19
Appendix II .......................................................................................................................... 21
Appendix III ......................................................................................................................... 22
Appendix IV......................................................................................................................... 24

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Introduction

The Capital Asset Pricing Model (CAPM) is a practical tool in portfolio management and

in academic research. And it is the dominating capital market equilibrium model. (Koo and Olson

1). In view of, this paper utilizes the framework of the CAPM to analyze the International Business

Machines Corporation (commonly referred to as IBM) stock value. With the model, we expect to

explain the variation in the rate of return on a security as a function of the rate of return on a

portfolio consisting of all publicly traded stocks (Market portfolio) (Hill 79).

In particular, I am interested in the interaction between risk and return. And how it

contributes to the construction of the portfolio. In other words, maximize a portfolio return and

minimizes the portfolio risk. As Markowitz suggest, the optimum portfolio involves selecting that

combination of securities that yields the best combination of expected return and risk (Naylor and

Tapon 1166). That is a “mean-variance-efficient” portfolio.

Our hypothesis states that the systematic risk of a security as measured by the market

model beta is the suitable measure of risk. Consequently, I apply econometric tools in order to

proof the reliability of the betas estimated from the historical price (Koo and Olson 1). Further,

this paper discusses the beta and its origin. In the CAPM framework, the beta is essential. For the

reason that, it is necessary to calculate the systematic risk as well as the estimated security return.

Thus, it leads to relevant topics of discussion in this paper. Such as, investment decision and

diversification. Being that, the following research goes through the following procedure:

 First of all, we discuss the development of the theoretical framework and its possible

different uses. Then we proceed with the model specification, variables and estimator

discussion; the equilibrium, assumptions, and implications.

 Secondly, we move to the estimation results and hypothesis test.

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  Thirdly, it is discussed (theoretically) how the results can be uses for investment decision

and diversification. And the usefulness of the model in the real world.

On the whole, I hope the following paper contribute to further understanding of the risk

management. And the application of the Capital Asset Pricing Model to underlying assets.

However, I am aware of the critics of the model assumptions and the model empirical record.

Nonetheless, the analysis the expected return analysis conditional to risk is an interesting topic of

discussion.

Capital Asset Pricing Theoretical Development

A common concern in finance is how the risk of an investment should affect its expected

return (Perold 3). The Capital Asset Pricing model based on Markowitz theoretical framework was

the first step in the understanding of risk and expected return. Markowitz exposed that the variation

on the return on a portfolio of financial securities depends not only on the risk of the individual

securities in the portfolio but also on the relationship (covariance) among these securities in the

portfolio (Naylor and Tapon 1166). In fact, “… showed that the variance of a portfolio of securities

may be less than the smallest variance of an individual security if there are sufficient covariances

among the securities” (1166). In probability theory, covariance is a measure of how much two

random variables change together. In the present analysis, it implies the relation of the stocks.

Particularly, in equilibrium, Markowitz model states that a security is expected to yield a

return proportional to its systematic risk (the risk that can not be diversified in a portfolio). The

greater the systematic risk, the greater the valuation of the securities (1166).

In the 1940s and 1950s, little was understood about the relation between risk and expected

return. Prior to the development of CAPM, it was believed that a firm that can be financed mostly

by debt was safer (assume to have a low cost of capital). On the other hand, a firm that can not

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manage its debt was riskier (high cost of capital). Yet, the explanation was not enough. Assuming

a static world, the value of an asset (firm) does not depend on how it is financed, as shown by

Modigliani and Miller 1958. (Perold 5)

The Capital Asset pricing model granted the first coherent answer to the value of an asset.

Its development came early the 1960s by William Sharpe (1964), Jack Treynor (1962), John

Lintner (1965) and Jan Mossin (1966). Of course, parting from Markowitz premise; not all risks

should affect asset price, but the systematic risk. (Perold 3). The CAPM resulted in a Nobel Prize

for Sharpe in 1990. Further, decades later, the model is extensively used in many applications.

(Fama and French 25)

The CAPM applications include Valuation of a firm’s stock, capital budgeting, merger

and acquisition analysis, the valuation of warrants and convertible securities, decision-making tool

for portfolio investment, estimating the cost for firms, and others. (Naylor and Tapon 1166-1167)

Mathematical Model

For instance, the rate of return on any investment is measured in relation to the return on

a risk-free asset (opportunity cost). The resulting disparity is called risk premium. The reward or

punishment for taking a risk. In the CAPM theoretical framework, the risk premium on security j

is proportional to the risk premium on the market portfolio. The model may be written as follows:

(Hill 79)

𝑅𝑗 − 𝑅𝑓 = 𝛽𝑗 (𝑅𝑚 − 𝑅𝑓 )

“…where 𝑅𝑗 and 𝑅𝑓 are the returns to security j and the risk-free rate, respectively, 𝑅𝑚 is

the return on the market portfolio, and 𝛽𝑗 is the jth security’s “beta” value (79).” The beta indicates

the underlying asset volatility. Further, it is a measure of the elasticity of the security return in

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respect to the market return. More importantly, a beta less than one is assumed “defensive”. While

a beta greater than one is considered an “aggressive stock”. Put another way, if the beta is greater

than “1” the changes in the market return will result in changes proportionally larger in the security

return. It is essential for the investor to estimate a stock beta before purchasing it, in order to

manage risk. (79-80)

The beta theoretical framework was refined by Logue and Merville. It reflects industry

characteristics and management policies that determine how securities returns fluctuate in

relation to changes in the overall market returns. If the industry characteristics and management

policies remain static through time, the measure of beta will be relatively stable as well. In

contrast, if stability does not exist, the beta will not be stable. (Weston 25)

Model Equilibrium

In equilibrium, all assets must be held by someone. Particularly, for the CAPM model

achieve equilibrium in the market, the expected return of each security must be such that investors

conjointly choose to hold exactly the supply of the asset (Perold 13). “If investors all hold risky

assets in the same proportions, those proportions must be must be the proportions in which assets

are held in the market portfolio…” (16). Consequently, in equilibrium the portfolio of risky assets

with the highest Sharpe Ratio1 must be the market portfolio. As a result, a higher Sharpe Ratio can

not be obtained by holding more or less of any asset. Then it implies that the risk premium of each

security must satisfy 𝑅𝑗 − 𝑅𝑓 = 𝛽𝑗 (𝑅𝑚 − 𝑅𝑓 ). (16)

1
The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility. That
𝐸(𝑅𝑗 )−𝑅𝑓
is, 𝜎𝑗
.

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Assumptions

Surprisingly, at equilibrium all investors want to hold the same portfolio of assets. On

other words, the investors in a sense have a homogenous preference of risk and similar expectations

probability distribution. However, if this were to be the case a market would disappear at some

point. Since investor would not trade each other. But, the reality is investors are heterogeneous;

they have different views. Which leads to trade and formation of prices in the markets. (Hulls 10)

Behind the Capital Asset Pricing model, there are a set of assumptions simplifying reality.

A necessary evil for the model to be express mathematically. Mathematical models, in general,

need a set of assumptions in order to illustrate complex processes in the real world. Notably, the

CAPM made a number of assumptions in order to achieve the equilibrium explained above. It

includes the followings: (10)

1) First, investors decisions are subject exclusively to expected return and standard deviation

of the return of the portfolio. The condition is reasonable if the securities return is normally

distributed. Yet, in the real world, the returns from many portfolios have different

distributions (in many cases non-normal).

2) Also, it assumes that the nonsystematic risk (the diversifiable risk) for different investments

are independent. Similarly, it hypothesizes that returns from investments are only

correlated with each other as a result of the relation with the market portfolio. When in

fact, the case is otherwise, returns can be correlated with each other.

3) Further, the model presumes that investor centers their attention on returns over just one

period and the range of time is the same for all investors. When indeed, not the case.

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 4) Moreover, CAPM assumes that investor can borrow and lend at the same risk-free rate.

Though it can be true in normal market conditions, the possibility is only within the reach

of large financial institutions and not small investors.

5) Even more, the model does not consider tax. And even if it would consider it, capital gains

are taxed differently for each asset return. Which complicates the asset/s returns analysis

in the real world. Incidentally, investors also consider taxes when considering and

investment.

6) Lastly, the model assumes homogeneous expectation, investors expectations about the

return, standard deviations of returns, and returns correlation for available investments do

not vary from an investor to another.

Implications

Under those circumstances, it is evident that the Capital Asset pricing model is not a

perfect model. The normality in the returns can or cannot be a valid assumption. According to

Kwon, a normally distributed return is possible under two conditions: (1505)

1. Assets’ nonsystematic returns have zero means conditional upon the return of the market

portfolio.

2. There exists, at least, one investor who holds the market portfolio at equilibrium.

Yet, complete diversification among stocks in a portfolio is a challenging goal. In that case,

Condition “1” is difficult to achieve (Koo and Olson 2). Other alternatives have been explored,

such as model similar to CAPM for symmetric stable distribution, elliptical distribution, among

other attempts to relax normality (Kwon 1505).

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 Additionally, Fama and French states that CAPM’s simplifying assumptions result in the

model empirical problems. However, it could also be a product of the difficulties in implementing

valid tests of the model. To illustrate, the model indicates that the risk should be measured relative

to a market portfolio that can include not just financial assets, but also consumer durables, real

estate and human capital (25). Overall, the model’s issues are relevant enough to overrule many

applications. (43)

Econometric Model

The CAPM model shown in the previous section of this paper is a mathematical model. It

may be converted to an econometric model by adding an intercept (alpha) in the model (according

to the theory it should be zero) and an error term. May be written as follow: (Hill 80)

𝑅𝑗𝑡 − 𝑅𝑓𝑡 = 𝛼𝑗𝑡 + 𝛽𝑗𝑡 (𝑅𝑚𝑡 − 𝑅𝑓𝑡 ) + 𝜖𝑗𝑡 .

where 𝛽𝑗𝑡 (𝑅𝑚𝑡 − 𝑅𝑓𝑡 ) represents the systematic risk in period t and 𝜖𝑗𝑡 the non-systematic risk in

period t. Further, the “beta” is the slope. In other words, it indicates the change in the expected

security return given a change in market portfolio return. While “alpha” is the intercept,

theoretically it represents the extra return made from an exceptional portfolio performance. The

theory usually expects the alpha to be zero. (Hull 13)

Even more, the greater the systematic risk the greater the reward or the punishment for

taking the risk. On the other hand, the non-systematic risk is unrelated to the return from the market

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portfolio and may be diversified. Yet, both risk can lead to bankruptcy. However, the investor, in

theory, is more concern with the systematic risk. (Hull 8)

The hypothesis test for the model is the following:

H0) j=0, case it is not statically significant.

H1) j ≠0, case it is statically significant.

If the beta is “zero”, there is no systematic risk and the expected return is equal to the Risk-

Free asset. Even more, it implies that for the given sample the systematic risk is not related to the

security return and the beta is unreliable. otherwise, it means the beta is a suitable measure of risk.

Estimation method and Data

The method applied in this paper to estimate the CAPM model is the Ordinary Least

Square. In particular, we regress excess returns on the IBM stock (𝑅𝑗 − 𝑅𝑓 ) against excess returns

on S&P 500 index (𝑅𝑚 − 𝑅𝑓 ). In order to estimate the IBM beta. (Spiegel and Stanton)

Further, the source of the data collected is Yahoo! Finance: IBM (IBM), S&P 500 (^SPX), and 3m

T-Bill (^IRX). However, the collected data is converted in order to obtain the monthly returns. For

the purpose of, the return of both, the security and the market, is estimated by calculating the

growth rate of the adj. close price of the stock. On the other hand, the Risk-free return is estimated

from the 3m T-bill rate. Since the shorter maturity T-bills are relatively volatile. However, the 3m

T-bill need to be converted to a monthly rate. (Spiegel and Stanton)

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 Hence, the dataset consists of IBM and S&P500 excess return over Risk-Free assets (3m

T-bill transform to a monthly rate). And the time series period is 1996:02-2016:03. (See Appendix

I)

Results and hypothesis test

For a start, both the excess returns of IBM and the S&P500 for the time period of 1996:02-

2016:03 are stationary series, accordingly, with the Augmented-Dickey-Fuller test at all common

critical values (See Appendix I, second page). In other words, “its mean and variance are constant,

and the covariance between two values from the series depends only on the length of time

separating the two values” (Hill 476). The main reason the we want a series to be stationary is to

avoid a spurious regression; obtaining apparent significant regression results from unrelated data

(Hill 482).

Under those circumstances, when IMB excess Return is regressed on the S&P500 excess

Return for the given time series. The following model is estimated: (See appendix II)

̂𝑅𝑒𝑡𝑢𝑟𝑛𝑡 = 0.4858628 + 1.050215 ∗ (𝑆&𝑃 500 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛𝑡 )

𝐼𝐵𝑀 𝐸𝑥𝑐𝑒𝑠𝑠
𝑠𝑒(𝛽̂
𝑖) = (0.04044105) (0.0913989)
𝑡= (1.20) (11.49)
𝑅 − 𝑠𝑞𝑢𝑎𝑟𝑒 = 0.3549 𝑛 = 242

Notably, the estimated model for the given sample agrees with the Capital Asset Pricing

Model Theory. Overall, there is evidence that there is a trade-off between risk and return. Higher

expected returns generally can be earned only by accepting higher risks. The expected return

should be consistent with the systematic risk the investors bear. (Hull 19)

To start with, the model slope indicates that when the S&P500 excess Return increase in 1

unit the estimate IBM excess return increase in “1.050215%". Accordingly, it can be said that the

trade-off between the estimated risk and estimated return is “1.050215%" . Also, given the

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estimated beta exceeds “one”, it is considered an aggressive stock relative to the market (however

we do not apply the corresponding hypothesis test to confirm this). The CAPM slope or “Beta”

measures the volatility of the individual security relative to the market (Weston 25). Specifically,

in this case, it is measured by the ratio of the covariance of the IBM excess returns with the S&P

500 excess returns divided by the variance of S&P 500 excess returns (25).2

Further, the p-value for the estimated beta is “0.000%” given a standard error of

“0.0913989” and t of “11.49". As a result, we can reject the null hypothesis that beta is “0”.

Which means that the expected return related to the systematic risk.

Secondly, the CAPM estimated alpha indicates that when the S&P 500 excess return is

equal to “zero” the estimated return excess return for IBM is “ 0.04044105%" . However,

according to Fama and French, the intercepts or alpha in time-series regressions are positive for

assets with low betas and negative for assets with high beta (32). On the other hand, according to

Hull, it indicates a superior return for the amount of systematic risk taken. However, in many

Capital Asset Pricing Model estimations, it is hypothesized to be “zero”. Likewise, the estimated

model indicates its “zero”. That means its p-value is value is greater than 5%. Which indicates that

the probabilities of being zero are high enough in order for the value to be considered significant.

In that case, we re-estimate the model without including an intercept. In order to improve the

model estimation. The result is the following: (See appendix II, no intercept estimation)

̂𝑅𝑒𝑡𝑢𝑟𝑛𝑡 = 1.059522 ∗ (𝑆&𝑃 500 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛𝑡 )

𝐼𝐵𝑀 𝐸𝑥𝑐𝑒𝑠𝑠
𝑠𝑒(𝛽̂
𝑖) = (0.0911538)
𝑡= (11.62)
𝑅 − 𝑠𝑞𝑢𝑎𝑟𝑒 = 0.3592 𝑛 = 242

2 𝐶𝑜𝑣(𝑅𝐼𝐵𝑀 −𝑅𝐹 ,𝑅𝑆&𝑃500 −𝑅𝐹 )

𝐵𝑒𝑡𝑎𝑖 = 𝑉𝑎𝑟(𝑅𝑆&𝑃500 −𝑅𝐹 )

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 For Instance, the newly estimated model indicates that the estimated beta indeed have a

lower standard error, when the intercept is not included. Accordingly, it implies that the beta is

more precise. Further, the beta value increased by some decimal points.

However, the model R-Square remains practically the same, 35.92%. It means that the

model only explains about 36% percent of the IBM excess return variations. Even more, the 𝑅 −

𝑠𝑞𝑢𝑎𝑟𝑒 suggest the following: (Spiegel and Stanton)

𝐵𝑒𝑡𝑎𝑖 2 𝑉𝑎𝑟(𝑅𝑆&𝑃500 −𝑅𝐹 ) 𝑀𝑎𝑟𝑘𝑒𝑡 𝑟𝑖𝑠𝑘

𝑅 − 𝑠𝑞𝑢𝑎𝑟𝑒 = =
𝑉𝑎𝑟(𝑅𝐼𝐵𝑀 −𝑅𝐹 ) 𝑇𝑜𝑡𝑎𝑙 𝑟𝑖𝑠𝑘

The ratio between the market risk and total risk. Yet, it can be stated that the model

forecasting capabilities are not good. (See appendix III, for illustration)

Nonetheless, the estimated model shows some good features. For instance, the residuals are

stationary, according, to the Augmented-Dickey-Fuller test (at all common critical values). In other

words, its mean is equal to” zero”. More importantly, it indicates that IBM and S&P 500 Excess

returns are cointegrated. It suggests, a long-run relationship between the two variables (489).

Additionally, it makes evident that for the given sample the relationship is not spurious. (See

appendix III)

Moreover, the Skewness/Kurtosis tests for Normality suggest that the IBM excess returns

are normally distributed. In particular, this test is important. In theory, investors choose to invest

in assets subject to their expected return and the standard deviation of the return. If returns are

normally distributed, it is acceptable assumption and even a reasonable action for the investor. In

contrast, “if there is positive skewness, very high returns are more likely and very low return are

less likely than a normal distribution would predict; in the case of negative skewness, very low

returns are more likely and very high returns are less likely than the normal distribution would

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predict. Excess kurtosis leads to a distribution where both very high and very low returns are more

likely than the normal distribution would predict.” (Hull 10) (See Appendix IV)

Other statistical tests applied in the estimated CAPM suggest that residuals are not serially

correlated and that they are normally distributed. Overall, this implies the model’s standard errors

are reliable for the confidence intervals and consequently for a hypothesis test. However, according

to the model R-square, the model is not a good predictor of future or even the past. In other words,

the model does not explain reality in most of the cases. Even though, for the given sample it is

evident to be statically significant.

Investment decisions

According to Weston, “The expected return on the new project must exceed the pure rate

of interest plus the market risk premium weighted by 𝛽𝑗𝑡 , the measure of the individual project’s

systematic risk.” Mathematically, it is express as follows: (26)

𝐸(𝑅𝑗 ) − 𝑅𝑓 > 𝛽𝑗 (𝑅𝑚 − 𝑅𝑓 )

the relationship implies that every project with an estimated excess return above the market risk

should be accepted. While all another project below the market risk should be rejected. Overall,

investors seek to find assets with returns in excess of the levels required by the risk-return market

equilibrium relation. In theory, when such “excess returns” exist, the demand for such asset

increase inducing a rise in price until the return on the asset reach the equilibrium level. In other

words, 𝐸(𝑅𝑗 ) − 𝑅𝑓 = 𝛽𝑗 (𝑅𝑚 − 𝑅𝑓 ). (26)

In view of, if applied the stated above to the estimated CAPM. We have the following

inequality:

𝐼𝐵𝑀 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛𝑡 > 1.059522 ∗ (𝑆&𝑃 500 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛𝑡 )

13
graphically, it is the case, for every IBM excess return in time t above the estimated IBM excess

return in the same period of time. (see appendix III, for illustration). In theory, it indicates when

the IBM stock is undervalued. Inversely, when the stock is undervalued it is express as the

following:

𝐼𝐵𝑀 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛𝑡 < 1.059522 ∗ (𝑆&𝑃 500 𝐸𝑥𝑐𝑒𝑠𝑠 𝑅𝑒𝑡𝑢𝑟𝑛𝑡 )

the case, when the project should be rejected. Further, the model’s residual implicitly indicates in

when the IBM stock is overvalued or undervalued. When the residual is positive the stock is

undervalued and when it is negative it overvalued. (see appendix III, for illustration)

Portfolio Investment Decisions

In the previous analysis, the investment decision is base solely on the performance of the

stock. However, when holding a portfolio of assets, the investor not only consider the stock

performance. Assuming an investor could borrow and lend at the risk-free rate, he decides to invest

in the IBM stock only if it improves the portfolio’s Sharpe Ratio; the average return earned in

excess of the risk-free per unit of total risk 3. (Perold 13)

For the purpose of, the investor follows a rule to guide the investment decision. The rule may be

derived by understanding two circumstances: (13)

1) When the additional stock is correlated with the existing portfolio,

2) And, when the additional stock is uncorrelated with the existing portfolio.

According to Perold, the rule leads to the equilibrium risk-return relationship specified by

the Capital Asset Pricing Model. When the stock is perfectly correlated with the existing portfolio,

the stock’s risk premium must exceed beta times the portfolio risk premium. Equivalently, if

3
𝑇𝑜𝑡𝑎𝑙 𝑅𝑖𝑠𝑘 = 𝑉𝑎𝑟(𝑅𝐼𝐵𝑀 − 𝑅𝐹 ) = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑅𝑖𝑠𝑘 + 𝐹𝑖𝑟𝑚 𝑠𝑝𝑒𝑐𝑖𝑓𝑖𝑐 𝑟𝑖𝑠𝑘

14
𝐸(𝑅𝑗 ) − 𝑅𝑓 > 𝛽(𝑅𝑝 − 𝑅𝑓 ) where "𝑅𝑝 " represents the portfolio return. Adding the stock to the

portfolio will increase the portfolio’s Sharper Ratio. In other words, the Sharpe Ratio increase if

the stock’s expected excess return exceed that of the mimicking portfolio. Conversely, selling short

a marginal share of the stock will increase the portfolio’s Sharpe Ratio if 𝐸(𝑅𝑗 ) − 𝑅𝑓 < 𝛽(𝑅𝑝 −

𝑅𝑓 ).

Accordingly, the portfolio has the highest attainable Sharpe Ratio if 𝐸(𝑅𝑗 ) − 𝑅𝑓 = 𝛽(𝑅𝑝 −

𝑅𝑓 ) for every stock. Put another way, the excess return for each stock is equal to beta time excess

return of the portfolio. (15)

Hence, “For the market to be in equilibrium, the price of each asset must be such that

investors collectively decide to hold exactly the supply of the asset. If investors all hold risky assets

in the same proportions, those proportions must be the proportions in which asset are held in the

market portfolio- the portfolio comprised of all available share of the risky asset. In equilibrium,

therefore, the portfolio of risky assets with the highest Sharpe Ratio must be the market portfolio.”

That is

𝐸(𝑅𝑗 ) − 𝑅𝑓 = 𝛽𝑗 (𝑅𝑚 − 𝑅𝑓 ). (16)

15
Conclusion

To sum up, The Capital Asset Pricing model is the first step in finance in the understanding

of the risk and return. And the first coherent answer to the value of an asset. The CAPM is a

practical tool in portfolio management and in academic research. And it is the most common

capital market equilibrium model. Further, it tells that diversified investors lowers their expected

returns (Perold 22). Moreover, investors who hold undiversified portfolios are likely to be taking

risks for which they are nor being rewarded (22).

In general, The CAPM applications include Valuation of a firm’s stock, capital budgeting,

merger and acquisition analysis, the valuation of warrants and convertible securities, decision-

making tool for portfolio investment, estimating the cost for firms, and others (Naylor and Tapon

1166-1167).

Particularly, in this paper, we applied the Valuation of a firm’s stock and decision-making

tool for portfolio investment. On the whole, we concluded that the estimated beta was significant.

Even more, the models residuals proof to be uncorrelated and normally distributed. And the excess

returns proof to be cointegrated. As a result, the estimated model suggests that the market beta for

the given sample is an appropriate risk measurement, even though, The R-square suggest the model

is no good at predicting reality.

However, many papers suggest that the market model beta is not a reliable measure of

risk, furthermore, that it is statically unreliably related to the return portfolio. Consequently, it is

implied that it is not a good model for expected return base on risk-aggressive stock (Koo and

Olson 3). Fama and French, in the same line, states that CAPM empirical failings, is a problem

even for passively managed stock portfolios produce abnormal returns if their investment

16
strategies tilt toward CARP problems (44). It is possible that CAPM’s empirical problems

invalidate many of its uses.

Despite its many problems, it is still considered a useful model. The model functions can

be summarized as follows: (Perold 18)

 “The model can examine whether real world asset prices and investors portfolios conform

to the predictions of the model… Even if the model does not describe our current world

particularly well, it might predict future investor behavior- for example, as a consequence

of capital frictions being lessen through financial innovation improved regulation and

increasing capital market integration.” (18)

 Lastly, “the CAPM can serve as a benchmark for understanding the capital market

phenomena that cause prices and investor behavior to deviate from the prescriptions of the

model. (18)

 The CAPM may help as an introduction to further more complicated models.

Regardless of the mixed empirical performance, as a result of the CAPM, we think

differently about the relationship between expected returns and risk. And further about how assets

performance should be measured.

17
Bibliography

Weston, Fred J. “Investment Decisions Using the Capital Asset Pricing Model.” Financial
Management 2.1 (1973): 25–33. Web. 2 Apr. 2016.

Naylor, Thomas H, and Francis Tapon. “The Capital Asset Pricing Model: An Evaluation of Its
Potential as a Strategic Planning Tool.” Management Science 28.10 (1982): 1166–1173. Web. 2
Apr. 2016.

Kwon, Young K. “Derivation of the Capital Asset Pricing Model Without Normality or Quadratic
Preference: A Note.” The Journal of Finance 40.5 (1985): 1505–1509. Web. 5 Apr. 2016.

Kwon, Young K. “Derivation of the Capital Asset Pricing Model Without Normality or Quadratic
Preference: A Note.” The Journal of Finance 40.5 (1985): 1505–1509. Web. 2 Apr. 2016.

Fama, Eugene F., and Kenneth R. French. “The Capital Asset Pricing Model: Theory and
Evidence.” Journal of Economic Perspectives 18.3 (2004): 25–46. Print.

Perold, André F. “The Capital Asset Pricing Model.” The Journal of Economic Perspectives 18.3
(2004): 3–24. Web. 2 Apr. 2016.

Koo, Simon G. M., and Ashley Olson. “Capital Asset Pricing Model Revisited: Empirical Studies
on Beta Risks and Return.” University of San Diego. 2006. Print. 02 Apr. 2016.

Yahoo Finance. Yahoo finance - business finance, stock market, quotes, news. Yahoo Finance,
2000. Web. 2 Apr. 2016.

Hull, John C. Risk Management and Financial Institutions. 4th ed. United States: Wiley, 2015.
Print

Hill, Carter R., William E Griffiths, and Guay C Lim. Principles of Econometrics - 4th Edition.
United Kingdom: John Wiley & Sons, 2010. Print.

Spiegel, M., and R. Stanton. Lecture 14: Implementing CAPM. 2016. Web. 6 Apr. 2016.

18
Appendix I

19
 ADF test for the IMB excess Return (Stationary)

ADF test for the S&P500 excess Return (stationary)

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 Appendix II

IMB excess Return regressed on the S&P500 excess Return, with OLS,
Monthly rates and frequency 1996/02 – 2016/03,

No Constant

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Appendix III

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ADF test for the residuals (stationary)

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 Appendix IV

Skewness/Kurtosis tests for Normality for IBM Excess Returns

Skewness/Kurtosis tests for Normality for Residuals

Serial Correlation test for Residuals

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